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According to Bilal Hafeez, Research Analyst at Nomura, one of the surprising developments over the past year has been the breakdown of the correlation between rate spreads and major dollar-crosses.

Key Quotes

“Take the euro, it showed some correlation with 10yr rate spreads up until late 2017, but since then the ups and downs in the euro appear decoupled from rate spreads. It’s only when we start to look at forward rate spreads, so the differential in a year’s time (say 1y1y) that some semblance of a correlation returns. It would appear that FX markets are very sensitive to the possibility of an ECB exit from negative rates in the next year or two.”

“The other surprise has been that a dollar carry trade has not emerged as US yields are closing in on 3%, while euro and yen rates are still close to zero. A likely factor is that in real terms, that is, when adjusting for inflation, the real rate differential is not that high. Indeed, screening all currencies by real yields, we find the dollar does not compare well with much of EM.”

“Instead, the rise in Fed policy rates and quantitative tightening appears to be encouraging risk aversion among higher-yielding EM currencies, so the dynamic is more risk-off than risk-on and a search for carry. This suggests that the dollar may not necessarily fare so well against the euro or yen, but could perform well against the “highyielders” such as AUD and NZD in G10.”

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