Yield Curves, FX & LIBOR Trends

by Ashraf Laidi
Sep 23, 2009 20:17 | 57 Comments

While FX trading seems to become increasingly bifurcated (broad USD weakness & broad JPY strength or vice versa), the unfolding trend remains a concerted move away from the QE currencies (USD, GBP) and into the commodity/high yielders as well as the EUR. Emerging talk on whether the US dollar has become the new low-yielding vehicle for carry trades financing equities, commodities and currencies vehicle highlights the difference between the USD and JPY carry trades. The latter was driven by structurally low Japanese rates (sub 1.0% since for past 10 years), which were a reflection of Japans anti-deflation policy, its current account surplus and the resulting proclivity to save.

But with the US budget deficit outpacing the level of that twice the total of the twin deficits (trade and budget) prevailing in 2004 (now at nearly 10% of GDP), there emerges the risk of renewed steeping in the US yield curve (widening spread between long and short term rates) as short term rates are dragged down by falling US LIBOR rates and long term yields chase escalating govt debt (which remains on the rise despite slowing private sector and household debt).

Yield Curve Steepening and Dollar Flattening

The chart below shows the US yield curve (as measured by the 10-2 spread) has peaked out at 2.60-2.70% in each of the last easing cycles (1991 & 2001 recessions). Thus, each time the 10-2 spread neared 2.70%, the FOMC was at the end of its easing cycle. This time, the two main forces that could help the current steeping exceed the highs of 1992 and 2003 are soaring US govt debt and secular decline in the US dollar. From a debt standpoint, despite evidence of household deleveraging in Q2, Federal debt issuance shows no sign of abating, especially when seen through the treasury auctions, which continue to reach new record issuance every month. From an FX standpoint, the dollar's heightened vulnerability emerges from its low yield and recurring role as a funding vehicle for the global recovery (or stability) play. Such vulnerability will remain despite the USD's preservation of its role as a reserve currency. Meanwhile, we see no change in the notion that rising risk aversion is the only viable source of any durable dollar rebound.

Yield Curves, FX & LIBOR Trends - Yldcurvesep 09 R (Chart 1)

For more analysis on how to use the US yield curve in gauging moves in USDJPY and Fed tightening, see chapters 6 and 9 of my book

The Fed could hope to alleviate the steepening yield curve by renewing its program of asset purchases (not an option from an exit strategy-minded central bank). But any sign of extending the asset-purchase program would entail an extension of QE and a green light for traders to send the currency into danger territory. Opting between fast USD selling and excessive yield run-up is one of the Fed's many dilemmas. Such vicious circle remains the principal driver for hedge funds and other central banks to accelerate their build up of precious metals, which bolster the case for $1,200 per ounce in gold before year-end.

Oversold vs. Undervalued

The USD may be oversold in terms of excessive optimism in equities, USD shorts in futures markets and the excessive ascent in other currencies whose economies remain in or close to QE, but not necessarily undervalued as soaring debt deficit nears 10% of GDP as well as the fact that US growth remains negative (disproving the FIFO hypothesis that US would enter and exit recession before the rest of the world). With Germany, Norway, Australia, S.Korea, Hong Kong and New Zealand each back into positive GDPO growth), such broad evidence of economic stabilization outside the US offers tremendous justification for asset managers to take diversify their stock selection out of the US.

2005 and 2008

Some historical perspective also helps. Ever since the dollar bear market began in Q1 2002, the US currency has had 2 legitimate recoveries; the 2005 rebound, which largely resulted from the temporary tax holiday (Homeland Investment Act) designed to incentives US multinationals to repatriate earnings; and the 2008 rebound driven by the stampeding out of commodity and emerging market plays into safer USD-denominated cash. The 2005 rebound was also associated with the Federal Reserve being the first major central bank to raise rates following the 2001-02 recession. Not only the Fed is highly unlikely to precede any major central bank in raising rates, but any tax holiday from the Obama administration would surely be mimicked by other (as Japan is already proposing).

And so the only durable means for the USD to avoid such developments would be for the US recovery to be consumer-based . But as the transmission mechanism between the bank liquidity and consumer demand remains broken by weak bank lending, continued foreclosures and rising unemployment rates, the demand source for the necessary increase in the next earnings season will remain tepid at best.

No Wrap-up without Reiterating GBP Bearishness

Excluding USD, GBP emerges as the broad underperformer even during improved risk appetite such as today, followed closely by JPY. Plummeting sterling LIBOR rates in the aftermath of bank of England Governor King's "negative interest rate" reminders and Lloyds' failed bid to exit govt asset protection program are likely here to stay especially amid an expected continuation of the BoEs QE.

This suggests that GBPUSD and GBPJPY would re-emerge amid the most notable losers during the next wave of risk aversion (GBPUSD capped at $1.6720 and GBPJPY capped at 153, eyeing 145.05). This would be closely followed by CADJPY, NZDJPY and AUDJPY. The chart of LIBOR rates below cogently illustrate the extent of the speed of USD LIBOR falling below Japan's zero-range rates as well as GBP LIBOR's continued decline, which should soon reside in the territory of JPY and USD.

Yield Curves, FX & LIBOR Trends - LIBOR SEP 09 (Chart 2)

Comments (Showing latest 10 of 57) View All Comments
Monica
London, UK
Posts: 4
12 years ago
Oct 16, 2009 22:59
Ashraf,

Thank you for having taken the time to reply and for sharing your thoughts.

Kind regards
Ashraf Laidi
London, UK
Posts: 0
12 years ago
Oct 16, 2009 19:12
Monica, the next decline in EURGBP is only likely to be of a corrective nature, unlikely to extend below 0.87. 50% chance we will retest 0.89. Then we could gradually regain 0.95 and 0.97.

Ashraf
Monica
London, UK
Posts: 4
12 years ago
Oct 16, 2009 15:13
Ashraf,

First of all, apologies for not being able to contribute to the forum with any personal comments. I am not a trader or a speculator and have little knowledge of the subject matter.

I read your article "Deflation Threat to QE Currencies" posted the 14/10 on The Market Oracle sitehttp://www.marketoracle.co.uk/Article14204.html) and, given the recent rally of GBP, would like to know if you still stand by the view expressed therein with regard to EUR/GBP.

I have been agonising for months whether and/or when to exchange my little pot of Euros into as I would like to be able to buy a little place to live in eventually.

Any comments would be very much appreciated.
Thank you.
Ashraf Laidi
London, UK
Posts: 0
12 years ago
Oct 11, 2009 15:51
bock, the yield bounce has been quite substantial, which weighed on the yen. but i hesitate to call the end of the yen rally. past 6 months has shown plenty of short-lived bounces in yen crosses and i see this one to be limited at 92-93 against USD.

Ashraf
bockdharma
Indiana, United States
Posts: 3
12 years ago
Oct 11, 2009 2:42
Ashraf--I hope you are having a relaxing weekend. My question comes from concepts in this curve article, the last IMT on Friday, and the workbook page on yields and yens crosses. There were plenty of jolts this past week--namely the RBA hike, the poor treasury auctions results Thurs, and great jobs #'s out of both AUS and CAD. So Friday we see a very nice spike in yields and the curve steepens. What really catches my eye here Friday is the tremendous yen weakness that on W and Th seemed more like noise or covering.

The workbook posts a great slide on the correlation between yields and the yen. What I am asking here is do you see a major turn here on the yen, assuming we continue to see UST yields continue to play catch up with competing global assets? Therefore, this week appears to be, at least fundamentally, a major turning point and line in the sand for the YEN. Yes or No?

Thanks in advance for any insight you may have the time to share....
Ashraf Laidi
London, UK
Posts: 0
12 years ago
Oct 8, 2009 20:15
raj, floor is falling fast for USDCAD. lets see if we clsoe above 1.0525. watch out for Canadas job numbers tomorrow. expected to see a decline again after that increase in August .

i see 1.45 in EURUSD for now, especially if we again fail 1.4860s

Ashraf
14raj
Kolkata, India
Posts: 210
12 years ago
Oct 8, 2009 18:30
Ashraf,
the way USd/CAD and USD/JPY is behaving its something like they got some support at 1.0550 and 8800 level respectively. May be my long positions in these two pairs made me think like this. Thats I want to know your view. I have long in USD/CAD at 1.0625 and at 1.0525 and in Yen i have at 88.15 and at 89.00 levels.Even in one post you said that DX is taking support near 75. Can we see Euro/Usd at 1.4460 level soon?
Regards,
Rajib.
Ashraf Laidi
London, UK
Posts: 0
12 years ago
Oct 8, 2009 17:27
Abood, not sure about the "perfect point", but continues to fail the 72.50 resistance (right shoulder) so selling at 72.30-50s with a stop at 73.10 and initial limit at 70.50

Ashraf
Abood26
Damascus, Syria
Posted Anonymously
12 years ago
Oct 8, 2009 16:58
Hello Ashraf what is the perfect point to seel OIl and Eur/USd
Thanks
Ashraf Laidi
London, UK
Posts: 0
12 years ago
Oct 8, 2009 15:51
EVERYONE, my USDCAD view from the last 3 days on IMT is UNCHANGED
1.0525 remains is a big support equivaklent of 95 US cents to 1 Canadian dollar. Upside target starst 1.0660. watch out from Canadian jobs tomorrow.

Again, please read recent IMTs.

AUDUSD downside limited to 0.87 for now. again, more downside in AUDJPY.

Ashraf