The 02-year spread continues to drive EURUSD

Introduction

The 02-year yield is a good proxy for central bank monetary policy. This is because the short end of the curve adjusts quickly to changes in the cost of capital. As such, we can look at the spread between two regions' 02-year notes to get an idea on how the market views their respective monetary policies.

Spread vs. EURUSD

Source: www.tradingview.com

For example, consider the spread between the German 02-year note (as a proxy for the Eurozone) and the US 02-year note (top chart). Here, we see that a higher trough (HT) followed by a higher peak (HP) has charted. This implies that the spread is widening in favour of the German 02-year note. Our interpretation is that the market views the ECB as relatively more hawkish than the Federal Reserve.

This is a primary driver of the EURUSD pair (middle chart). The EURUSD has also charted a higher trough (HT) followed by a higher peak (HP). As such, it is also in uptrend. Not surprisingly, the correlation coefficient (bottom chart) is robust, with a 77% reading. I.e., there is a close correlation between the 02-year spread and the EURUSD.

We now focus on the higher trough, HT*. If we see more movement up in the spread, and the correlation coefficient holds, this should filter through to a higher EURUSD.

ECB Sintra Symposium

The ECB Symposium in Sintra kicks off today. We expect a general hawkish tone from participants. Regarding the Eurozone, the economic outlook is deteriorating. For example, yesterday's German ifo Business Climate reading deteriorated from 91.5 to 88.5, with 90.7 being the forecast. We have also seen generally weak manufacturing PMI readings out of the region, amongst other date points.

Nevertheless, central banks are primarily focusing on their price stability mandate with inflation clearly pushing policy. The ECB will hike in July and probably again in September.