The US dollar is having one of its best days in three months. It is coinciding with the push in 10-year yields above 2.70% and the two-year yield at its highest level since 2008 (~2.13%). It may have been encouraged by a push back against the ECB hawks who want to end QE as soon as possible and pre-announce an end date. 

The doves suggest that there continues to be a consensus for tapering the current purchases after September. This can still change, of course, but the idea is that there will not be an abrupt end in September. Because of the sequencing, which Draghi reconfirmed and underscored, the longer the purchases, the further off the rate hike.

We argue that the market has exaggerated the timing of peak divergence. It is still at least a year away. The market feels more confident that the Fed will be raising interest rates this year starting in March. By the time the ECB will raise its negative 40 bp to negative 30 bp or negative 20 bp, the Federal Reserve will have raised interest rates by between 50 bp conservatively and 100 bp by their own estimation. The Fed’s balance sheet will shrink by roughly $420 bln this year, while the ECB’s will expand by at least 270 bln euros and the BOJ’s by around JPY40 trillion.

Rate differentials were not the driver last year, but that does mean that they should be disregarded. We recognize that there is not a linear relationship between interest rates and exchange rates, but see the continued widening of the differential rate differentials, mostly due to an increase in real interest rates, though term premium is also rising. We think the market has been too quick to discount the constructive US policy mix and too quick to anticipate the changes in BOJ and ECB policy. 

Market positioning and sentiment seems extreme, but today’s bounce does not appear to be sufficient to break the bears. We see today’s price action as a retracement of the last leg down that began January 17-18. Key support for the euro and sterling held (~$1.23 and $1.3980 respectively). The critical level for dollar-yen is near JPY110.25, but it could not even resurface the closer hurdle near JPY109.50.