Currency Market Health, Structural Changes, Monetary Policy

The result of false dichotomies from central bank messages is a once bifurcated market in overnight interest rates and yields to now a full embed of interest rates and yields. Structurally, installation in interest rates inside yield curves is extraordinarily unhealthy and a phenomenon not seen since the misunderstood free float markets of the 1970’s and 1980’s.

Perfect positions between interest rates and yields are interest rates must trade below yields in a buy low, sell high approach to finance markets. A potential automobile purchase from a consumer perspective is to obtain the lowest finance rate while the loan purchaser objective is to sell the loan to the market for the highest market rate. Meld of interest rates and yields locks interest rates to the lowest common denominator and lacks the stair step ability across maturities.

The two exclusions to the new submergence is NZD and JPY. For Japan, JPY yields and interest rates always traditionally traded above Germany as is the current case to the 9 year yield. JPY yields traditionally traded above USD yields yet now trade well below. The implications for the BOJ and RBNZ is ability to slash interest rates. Yet yields and interest rate positioning is not the overall driver to RBNZ further OCR cuts as the impetus remains the Trade Able to NON and Exports to Imports.

Australia, Canada, Germany, France, USD, UK and CHF all share the interest rate / yield commonality. What this means for markets is not only interest rates at lowest depths since the 2008 crisis but trading ranges and volatility will remain suppressed. The pairs with the best volatiity remains EUR/USD, USD/JPY, USD/CAD and EUR/JPY.

Least favored in current interest rate scenarios are CHF, AUD, NZD and GBP although GBP ranges are beginning to open much wider but may be due to expected movements from the Brexit vote. Daily GBP pip ranges all last week were located at 72 pips.

What volatility means for EUR/USD is 6 months of 500 pip ranges yet under normal functioning markets, EUR/USD ranges should be easily 1000 pips. Why range suppression is due to the current interest rate /yield environment as European interest rates once traded above German yields before the ECB went negative. As the ECB dropped interest rates, EUR/USD trended.

What today’s interest situation means is more ranges ahead without trends until the impetus hits for the big move that lies ahead. Part of the explanation to interest rate / Yield embed is July 1st the ECB cuts interest maturities to 5 from 8 and 15 in 2014. If the current interest rate/ yield conundrum holds for Europe after July 1st then EUR/USD will experience further volatility / range compression.

The long held view is the ECB is trying to follow the Australia model and turn EUR/USD into range and pip movements of AUD/USD. If true, EUR/USD ranges V DXY may see constant 200 pip ranges every month long into the future.

Brian Twomey, Inside the Currency Market,