One Tsunami about to end? ...Is another in the making ?
The talk of the town right now is whether the US Fed Reserve is indeed going to raise interest rates next year. Looking at US Dollar index, we may conclude that markets indeed are pricing-in interest rate hike. However US ten year treasury yields are not responding accordingly. benchmark rates are near 2.4% and in downtrend off late, while US Dollar is strengthening. So how come the strength in US Dollar Index? Is it because of geopolitical tensions? or because falling benchmark rates across the advanced nations. Let me show you screenshots of bloomberg website showing the performance of bond Yields in US, EU, UK and Japan.
UK Gilt Yields
German Bund Yields
Troubled Nation in EU
Japan Bond Yields
Some Observations -
On Yearly basis, Yield curve in US and UK are Inverting i.e. short end of 2-yr and 5 yr yields have shot up while the long end of 10-yr yields has gone down.
This to major extend can be attributed to FEd and BOE purchases on the long end. but the short end seems to have gone up on expectations of interest rate hike.
For Eg - In UK, 2 year Gilt yields - proxy for interest rate expectations shot up 115% in last one year while GBP/USD rallied from 1.4809 to 1.7192 i.e. 16%.
In EU, especially Germany Bund yields have declined across the board indicating not only expectation of low interest rates but of unconventional policy tools ..ahem ahem! as well
What I Infer
US Fed QE may end this year and interest rates could be hiked in next year. Same goes for Bank of England however Bond markets across EU indicate that unconventional measures are surely coming up from European Central Bank
Where does this all lead
Liquidity Tsunami or Deluge shall continue. Even before the ongoing Tsunami ends, the next one shall begun.
If the Central bankers want to avoid the bubble burst in financial markets, this is the only scenario where bubble remains intact. ECB shall have to pump liquidity before US Fed and or BOE raises interest rates
In any case Bond yields in US stay low ...
If Fed and/or BOE tightens policy prematurely without ECB easing policy at same time, risk assets more importantly Equity markets would fall pushing US bond prices higher and yields lower.
If Fed/BOE tightening is accompanied by ECB easing the bond bubble keeps going along with equities.
So whats behind the current strength in US Dollar
The recent strength in USD is not due to expectation of interest rate hike in US but due to expectation of fresh unconventional policy measures from ECB and delay of interest rate hike by Bank of England.
Hence despite weak Treasury yields on long end, USD has strengthened.
Furthermore, the short end has not gone up enough so as to infer that interest rate hike is done deal in US and UK.
What If Unconventional policy measures don't come from ECB ?
The straight answer is Bond bubble bursts in EU. Check out the pic of bond yields of troubled nations of EU. Italy and Spanish bond yields are almost equal to that of US. German 2-yr yield is below 0% and 5-yr yield is closer to 0%. and look at Greek bond yield: its down by 463 basis points to 5.56%. French yields too are extremely low
Such low yield in troubled nations can be attributed to low growth but I feel major portion of fall is due to expectation of unconventional policy measures from European Central Bank.
Hence, Unconventional policy measures are now necessary to avoid bursting of bond bubble rather than propping up EU economy.
Not only that, but if ECB fails to ease, bond yields would rise sharply bringing back the debt crisis.
What about EUR/USD
In above scenario, EUR/USD looks bearish. If ECB conducts QE, EUR shall fall slowly or may even rise as markets price-in the actions in advance.
On the other hand, if ECB does not ease, it shall fall rapidly as bond bubble bursts.