BNY Mellon: EUR/USD, Yield Gaps And Volatility

BNY Mellon: EUR/USD, Yield Gaps And Volatility

Outlook Currency Politics

By Simon Derrick, Chief Currency Strategist, BNY Mellon

  • Post-2008 breakdowns in the relationship with yield differentials and the emergence of periods of low volatility have typically coincided with shifts in Fed QE/QT policy
  • The rekindling of these relationships typically emerged as volatility in underlying asset markets picked up

Since December one of the features of trading in EUR/USD has been a collapse in the correlation with key yield differentials.

At present the rolling 200-day correlation between EUR/USD and the 2-year Bund/Treasury stands at -12.9% while for the 5 year gap the reading comes in at -32%. Further out even the 10-year gap shows only a mild 29% correlation.

Since the GFC it has been rare to see a break down in the relationship between yield and the performance of EUR/USD in this fashion.

The first time this happened post 2008 came in 2009 just after the introduction of significant QE programmes by the Fed and others and ahead of the start of the first Eurozone crisis.

During this period the 2-year Bund/Treasury yield gap stagnated while the EUR crept higher. 21-day realised volatility fell from above 13% to around 8% (the lowest level hit since August 2008 just after the EUR finally peaked out).

The second time came in Q2 2014 just as the Fed was began tapering its asset purchases and just ahead of the introduction of a negative deposit rate by the ECB.

The 2-year Bund/Treasury spread was stagnant through the early part of this period while the EUR crept to a multi-year high. 21-day realised volatility remained between 4% and 6%.

The end to the calm came as the ECB’s negative deposit rate spurred a flow of money into the USD which, in turn, fed into volatility in a range of assets (notably oil) and then back into currencies such as the RUB.

The last time it happened was between September 2017 and June 2018. This coincided with the start of the Feds balance sheet reduction programme. During this period the 2-year Bund/Treasury yield gap narrowed at a steady pace.

In the period up to the start of January 2018 21-day realised volatility declined to around 5%. However, between January and February volatility picked up as US markets and then the USD reacted negatively to rising yields.

Although calm returned between March and May, the start of the Italian crisis saw the return of a more normal relationship between the yield gap and EUR/USD and a normalisation of volatility.

What can be gleaned from this?

Firstly, since 2008 periods of low volatility in EUR/USD have coincided with shifts in the Fed’s programme of asset purchases and sales. It’s therefore consistent that the current period of calm has coincided with the Fed indicating that it would soon bring its balance sheet reduction programme to a close.

Secondly, FX volatility has returned when underlying asset markets became more volatile. While there was no one cause of the underlying asset market volatility in both 2009 and 2014 the correlations between EUR/USD and shifts in yield differentials did reassert themselves rapidly. This was reflected in a normalisation in realised volatility.

Finally, it was noticeable that in 2018 the recovery in volatility proved fleeting. This might have been down to early expectations the Fed would act in the face of asset market volatility.