In the past few months, we argued that the rise in uncertainty over inflation expectations and economic output will certainly levitate the term premium and therefore steepen the 2Y10Y yield curve. For instance, figure 1 (left frame) shows that the US 10Y term premium has historically strongly co-moved with the unemployment rate and that the deterioration in the job market amid strict lockdown measures could lead to higher long term yields. Figure 1 (right frame) shows that the sharp yield curve ‘steepener’ that occurs prior or during economic recessions is mainly coming from the dramatic rise in the term premium.
Even though we do not expect the 2Y10 yield curve to dramatically steepen as during the Great Financial Crisis (by 3 percent), we still see a higher retracement on the 2Y10Y towards 1% (currently trading slightly below 70bps).
At the same time, we are also bullish on the US Dollar as a hedge against rising uncertainty over a range of macro events (US elections, Brexit, new lockdowns imposed by governments…). In the past 18 months, it is interesting to see that a cheaper US Dollar has usually coincided with higher equities (SP500) and vice versa (figure 2); therefore, we think that being long the US Dollar at current levels offer investors a good hedge against a sudden reversal in equities.
However, the question now is: can the US Dollar appreciate as the yield curve continues to steepen? Figure 3 shows an interesting relationship between the greenback and the 2Y10Y in the past 15 years; a steeper yield curve has generally been associated with a cheaper US Dollar and not a stronger USD.
In this article, we define the term spread of a specific country by the difference between the long-term (10Y) and the short-term (2Y) sovereign yield, which is also referred as the yield curve. As we mentioned it in one of our previous Great Chart articles (here), empirical research has shown a significant relationship between the real economic activity of a country and the yield curve. In today’s edition, we chose to look at the historical developments of the term spread differentials, between the US and Germany and the US and Japan.
Over time, we notice that the term spread has some interesting co-movement with the exchange rate. For instance, between 2005 and 2017, a widening term spread differential between the US and Germany was favourable to the USD/EUR exchange rate (here), meaning that the Euro was appreciating when the US yield curve was steepening more significantly than the German one. However, we saw that the relationship between the two times series broke down in early 2017 and has actually reversed over the past 14 months (here). In other words, based on the current market levels, the 2Y10Y term premium in Germany offers 56bps more than the US. Hence, as the term structure in the US has flattened strongly relative to Germany (yield curve steepened from 50bps in July 2016 to 118bps), the US Dollar depreciated.
This chart shows the evolution of the term spread differentials – between US and Germany and between US and Japan – since 1985. We can observe a strong correlation between the two times series over the past 30 years, with the term spread differential against Germany trading at -57bps, its lowest level since June 2006, and at 42bps against Japan, its lowest level since June 2008, respectively. An interesting observation comes out when we look at the spread between the two TS differentials (US-Japan vs. US-DE), which simply comes back at looking at the cross term spread differential between Germany and Japan. At the exception of the year 1992, the DE-Japan TS differential has always traded between -1% and +1%, and is currently standing at the high of its long-term range. The TS differential currently trades at +1% on the back of a steepening German yield curve since the summer of 2016 (2Y10Y moved from 52bps in July 2016 to 119bps today). It it a good time to play the convergence between the two term structure, i.e going long the German 2Y10Y term spread and short Japan 2Y10Y? The risk of the trade is on Japan side, as shorting the 2Y10Y would imply a steepening yield curve with either the 2Y yield going down or the 10Y rising. With the current BoJ ‘yield curve control’ (YCC) policy, we know that a steepening yield curve in Japan is difficult for the time being, but it will be interesting to see where TS differentials stand in a couple of months.
Chart: Term spread Differentials – Japan and Germany vs. US (Source: Reuters Eikon)