Run On Dollar And Yen Continues

The main driver of the foreign exchange market is the continued reassessment of the trajectory of monetary policy in the UK, EMU, and Canada. The OIS market does not show that higher rates are discounted for the next policy meeting (August, September, and July respectively), but rather there is greater confidence that, outside of Japan, peak monetary stimulus is behind us.  

We have argued that the interest rate differentials more than external imbalances and politics explain movements in the foreign exchange market.  This still seems to be the case, but in the opposite direction than we had envisioned. The US 10 year premium over Canada is the narrowest since Oct, over Germany since November and over the UK since February.  

At the shorter end of the curve, the US two-year premium over German fell to 191 bp earlier today, which is the smallest since February. The two-year premium over Canada was nearly halved to 31 bp from 63 bp last month. It is the smallest premium since last November. The US offers 102 bp more than the UK on the two-year money. That is down from 127 earlier this month and return the spread to its lowest level since January.  

We are concerned that the many are exaggerating the extent to which the ECB is truly mulling an exit from its extraordinary monetary stance, as one news wires claimed.  Draghi and Constancio were fairly clear on this point. Their focus is on inflation, not growth, and they do not believe that inflation has yet reached a durable and sustainable path toward its target. Therefore, a high degree of accommodation is still warranted.  Far from exiting its negative deposit and asset purchase regime, we expect the buying to be extended into next year, at the September meeting, and deposit hike from minus 40 bp over the year.  

Ahead of tomorrow’s EMU flash CPI, Germany and Spain are reporting their figures today. Italy reported yesterday, and the headline fell more than expected. In Spain and Germany, prices appear a bit stickier.In Spain, the headline pace slowed from 2.0% to 1.6%. The median result of the Bloomberg survey was for a fall to 1.5%. It appears to mostly the base effect as last June’s rise housing and utilities were not repeated. In Germany, most of the states the have reported have seen the year-over-year rate tick up. This risks the aggregate figure, due out later today, which is expected to decline to 1.3% from 1.4%.