Weekly Chart: Term Spread Differentials (US, Germany and Japan)

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 Weekly 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)

Term Spreads ALl

Weekly Chart: US Yield Curve vs. VIX (log, 30M lagged)

As a response to the recent surge in the market’s volatility (VIX), we saw lately an interesting chart that plots the 2Y10Y yield curve overlaid with the VIX (log, 30-month lagged). Even though we don’t necessarily agree with the fact that yield curves are a good predictor of recessions, we like to integrate it in our analysis as a supportive argument when presenting our outlooks as it summarizes a lot of information in a single chart. Previously, we presented the SP500 index versus the 2Y10Y yield curve (here), in which we emphasized that US equities can continue to rise (as the fundamental indicators) for weeks (2000) or months (2006/2007) despite a negative yield curve.

In this chart, we can notice another important factor, which is that the bull momentum in the equity market can persist even though market experiences an increase in price volatility (on an implied base). For instance, in the last two years of the 1990s (98/99), the VIX averaged 25%, 10 percent higher than in the last few years, while the SP500 was up 70% (the Nasdaq actually increased by 100% in the last quarter of 1999).

Hence, if we assume that the 25-year relationship between equity volatility and the business cycle holds on average, the constant flattening US yield curve over the past 2 years was suggesting a rise in the VIX.  The chart shows the persistent divergence between the two times series prior the sell-off; while the 2Y10Y had flattened by 200bps to 0.50% over the past couple of years, the VIX was averaging 10-12. The question now is: what to expect in the future for US equities, volatility and yields?

With the 10-year slowly approaching the 3-percent threshold, are US equities and volatility sensitive to higher long-term yields? As Chris Cole from Artemis pointed out in his memo Volatility and the Alchemy of Risk, there is an estimated 2tr+ USD Global Short Volatility trade (i.e. 1tr USD in risk parity and target vol strategies, 250bn USD in risk premia…). Can we experience another late 1990s period with rising LT yields, higher implied volatility without a global deleveraging impacting all asset prices?

In our view, it is difficult to see a scenario with rising LT yields combined with an elevated volatility (i.e. 20 – 25 %) without a negative impact on overall asset classes. Hence, if we see a persistent high volatility in the medium term as this chart suggests, the deleveraging in both bonds and equities by investment managers will kickstart a negative sell-reinforcing process, creating a significant sell-off in all asset classes with important outflows in the high-yield / EM investment world, hence leading to a repricing of risk.

Chart. US 2Y10Y Yield Curve vs. VIX (log, 30M lagged) (Source: Eikon Reuters)

USYield vs VIX

A CB surprise…

After October 15th last year, yesterday was another insane day in the market. We know approximately the impact of a lower (or higher) NFP report on the US dollar or a lower (resp. higher) than expected EZ inflation rate on Euro bonds; however when the surprise comes from a central bank, we saw the consequences…
But first, I am going to have just one quick digression before going for it, concerning the OMT.

OMT is legal

Almost a year ago, the German Federal Constitutional Court (GFCC) found ECB’s OMT bond-buying program illegal and incompatible with EU and German law. Given that the GFCC only has jurisdiction on matters of German domestic law, it decided to leave judgement to the European Court of Justice (ECJ). In his Opinion on Wednesday, the Advocate General Cruz Villalon observed that the program is compatible with the EU Law and that the ‘objectives are in principle legitimate and on consonant with monetary policy’. He added that the program is ‘necessary as well as proportionate in the strict sense, since the ECB does not assume a risk that will necessarily make it vulnerable to insolvency’. As a reminder, the Advocate General’s Opinion is not binding on the Court of Justice. THe judges are now deliberating and the Opinion is expected to reach its judgment by May.

The Euro plummeted by 100 pips to 1.1730 (9-year low) after the news, but came back above 1.1840 on the back of poor US retail sales figures. As a reminder, retail sales dropped 0.9% MoM on Wednesday, the most since June 2012, and missed expectations of a 0.1% decline.

However, the ‘recovery’ didn’t last very long as the single currency is currently trading at 1.1630 against the greenback. How come?

Definitely unexpected…

Yesterday morning, slightly before lunch time (Swiss local time), the Swiss National Bank announced that it was discounting the minimum exchange rate of 1.20 per Euro (that it has been ‘defending’ for the past 3-1/2 years). It also announced that it would go further into NIRP policy, pushing its interest rate on deposit balances to even more negative from -0.25% to -0.75%.

By letting the exchange rate float ‘naturally’, the consequence were brutal and EURCHF, which had been flirting with the 1.20 over the past couple of months, crashed to (less than) 75 cents per Euro, wiping out every single long EURCHF position, before ‘recovering’ to parity (now trading at 1.0140).


USDCHF is now trading around 0.8700 (back from above parity levels, 1.02 to be precise), and EURUSD was sold to 1.1568 before rebounding.

A Stressed Market

The Swiss curve is now trading in the negative territory for all the maturities until 10 years; the swiss market index tumbled to (less than) 8000 (almost 15 drawdown) and then stabilized around 8,400.

US yields are still compressing, with the 5-year, 10-year and 30-year trading at 1.18%, 1.72% and 2.37% respectively. I added a table below that shows the 10-year overall and definitely summaries the current ‘environment’. As you can see, Greece is the only EZ country where yields are trading at astronomic levels on the fear of a Grexit scenario in 10 days (See article here). I like the expression ‘the Japanization of Global Bond yields’ used by some analysts I read.

Capture d’écran 2015-01-16 à 10.35.47


Our favorites, AUDJPY and USDJPY, both reacted to the SNB comments ‘bringing down’ the equity market with them. AUDJPY plunged from (almost) 97 to 95.30 and is now trading at 95.60. USDJPY broke below 116.60 and dropped to 116.28; before that, it reached a daily high of 117.92 during the ‘early’ Asian hours.

The S&P500 index followed the general move and broke the 2,000 level (closing at 1,992), and is now trying to find a new low. Is it going to be a buy-on-dips scenario once again? Clearly, the equity market is ‘swingy’, however I don’t think we are about to enter a bearish momentum yet and I still see some potential on the upside. Therefore, USDJPY should also help the equity market levitate and we should see the pair back to 120.

Discrete poor US fundamentals

Yesterday was also marked by a poor jobless claims report in the US, which was totally forgotten of course but surged to 316K (vs. expectations of 290K). In addition, the Philly Fed, an index measuring changes in business growth, crashed from a 21-year high of 40.2 in November to 6.3 in January (missing expectations of 18.7), the lowest since 2014. I know these figures are quite not relevant for traders and investors, however I do think it is worth noticing it. As a reminder, US inflation rate (watched carefully by US policymakers) decreased from 1.7% to 1.3% in November and is expected to remain at low levels (between 1 and 1.5 percent).

Overall, the global economy still looks weak, and we saw lately that the World Bank decreased this year’s growth projections to 3% in 2015 (down from 3.4% last June). Major BBs declined their forecasts on oil and expect prices to remain low in the first half of this year. We heard Goldman’s Jeff Currie lately saying that prices of crude oil may fall below the bank’s 6-month forecast of $39 a barrel. Remember the chart I like to watch (oil vs. inflation vs. yields vs. equities).

The next couple of event to watch are of course the ECB meeting on January 22nd, followed by the Greek national elections on January 25 (see below). For the ECB meeting, it is hard to believe that the central bank will do nothing after the SNB’s announcement.


(Source: MS Research)