Here Is What Is Storing 'Potential Energy' For USD And GBP - Goldman Sachs
The move in US and UK front-end rates since the beginning of the year has been substantial – in fact, the decline in 2-year US and UK swap rates has been larger than the downward move in EUR and JPY equivalents (approximately -37bp and -31bp in the US and UK vs -24bp and -15bp in the Euro area and Japan).
Given central bank guidance towards rate hiking cycles – actual in the case of the Fed and eventual in the case of the UK – these upward sloping curves had the furthest to fall. It also implies that interest rates differentials moved against USD and GBP in favour of the safe haven currencies EUR and JPY.
How has the market’s view on negative rates changed in the US and UK? Exhibit 2 shows that the probability of negative policy rates 12 months ahead (assuming a constant 3m-OIS spread) has hit new highs in the last week following the BoJ's move to negative rates in late January (although it has fallen back after Friday’s US employment report). This is consistent with the fall in market rates and a shift in the rate distribution lower.
However, unlike the EUR and JPY curves, the skew of the US and UK curves continues to be towards higher rates. With both the Fed and the BoE continuing to point towards future rate hikes, the market still tilts the balance of risks towards higher rates – albeit at a very gradual pace.
Given our upbeat view on both US and UK activity and for the ability of both the Fed and the BoE to hike rates later this year, we view the market pricing as too dovish . In contrast, the EUR and JPY curves are likely to be dragged lower by both ECB and BoJ activism. Of course, there is a risk that aggressive cuts by the ECB and / or the BoJ will be a drag on global curves. But, in our view, gradual firming of inflation pressures in the US, followed by the UK, will provide support for continued front-end decoupling.
As a result, interest rate differentials currently flatter the EUR and JPY, and like a coiled spring, are storing up potential energy that will eventually benefit the USD and GBP.