EUR/USD Intermarket: US Yields Collapse Amid Supply Environment

EUR/USD Intermarket: US Yields Collapse Amid Supply Environment

Based on intermarket analysis, which helps explain why certain moves occur but most importantly, what are the current main drivers for a certain asset class, the vigorous rise in the EUR/USD exchange rate since April 24th, which has grabbed most headlines since the breakout of 1.15, can be mostly attributed to the reduction in bets towards any near term Federal Reserve rate hike.

As shown by the CME Group 30-Day Fed Fund futures prices, used to express the market’s views on the likelihood of changes in U.S. monetary policy, the contract has experienced a collapse, which resulted on the onset of the EUR/USD bull run, after finding a bottom around the 1.12 handle over 2 weeks ago.

Loss of confidence to believe on the Fed

The sharp decline in the Federal Fund rates has led to the 2-year Treasury yields catching a strong offer tone towards its current levels at 0.74% (the move down was initiated on April 26th and has been a one-way street), while the 2-year German yield has been gradually edging higher before topping out on May 3rd, with a subsequent decline to presently trade circa -0.5%.

The observations in the measurable intermarket correlations between EUR/USD and its respective sovereign (Germany and US as benchmark) yields, reflect that the bullish move in EUR/USD, including its most recent notable upside acceleration in May, which saw a brief drive above 1.16, was driven almost entirely by market participants pricing out further rate hikes by the Fed in coming months, causing big pain in the US Dollar across the board as a result.

Present rates only assign a 40% chance of another hike by September, which comes in stark contrast with the anticipation of 4 rate hikes projected by the Central Bank earlier this year; with that in mind, it is no surprise that the market had still more room to discount over-expectations on rates against the US Dollar, based on the divergence between what the Fed promised to deliver and the actual reality. To make matters worse, US data continues to argue for the Fed to maintain a very cautious approach rather than embark on more tightening.

Improvement in the US-DE yeild spread last 48h

The abrupt turnaround off trend highs in EUR/USD on May 3th, while occurring on falling US yields (pace of move slowed down last 2 days), it came mostly driven by a sharp reversal in 2-year German yields, showing an almost vertical downward slope n May 3rd. During these past 2 days, the XFFE contract has also moved off lows, which has also assisted to take prices down below 1.15. Not to mention that at current levels, macro players are probably salivating to re-engage in sell-side campaign should intrinsic valuations turn back in favour of the USD. It is well known that the ECB is unhappy to see the EUR/USD at these levels, as it makes any potential pick up in EU growth much more challenging. For now, the latest selling activity in EUR/USD can clearly be explained by an improved EUR/USD 2yr yield spread (within the context of a multi-week downtrend), despite having experienced a steadily higher VIX in the last 48h, which tends to be bullish for EUR/USD, as it communicates 'risk-off' conditions returning.

Commodities selling on USD weakness early May

Looking at the latest move in metals, such as Copper or the CRB index (commodity futures price index) since early May, one can gain additional insights that a more supply-led (risk averse) environment has settled in, as both assets have been on a steady decline despite weakness in the US Dollar, which should not be the case unless the market has a genuine interest to sell commodities, as these are not depreciating based on any USD strength effects. Meanwhile, the VIX has been rising in May, suggesting that the environment should remain fairly constructive for EUR/USD (risk on/off sensitive given high/low yield component).

Overall environment constructive for EUR/USD

To sum up, should the US-DE yield spread reclaim further lost ground while the VIX comes off highs, that would be indicative of a sell-side EUR/USD environment. However, there are little, if any signs, suggesting 2-year US yields may recover much from depressed levels, unless the Fed re-establishes credibility by raising rates in the immediate future and sends a message to the market, otherwise, the market appears to have, plain and simple, lost any sort of trust on the Fed acting, following successive dovish disappointing outcomes in recent FOMC meetings. More over, as long as commodities come off highs on lower USD and assuming EU yields remain steady, the prospects are for an elevated EUR/USD.