The following article was prepared for LeapRate by iForex.
During the last month of the first half of 2020, the Euro began to gain traction against the US dollar as concern over the spread of COVID-19 weighed on the greenback. The yield differential between the US treasuries and the German bund moved in favor of the bund which helped the euro gain additional traction.
During June the Federal Reserve, the Bank of Japan, the European Central Bank, and the Peoples Bank of China all made adjustments to their monetary policy stimulus. Technically, the euro started to form a cup and handle pattern which is a continuation pattern that reflects a pause that is likely to refresh higher.
The Yield Differential is a Driving Force
The yield differential has been one of the driving forces behind currency trading. The yield differential, in the forex markets, reflects the difference between one country yields at a certain tenor compared to other countries yields for the same tenor. For example, you might compare the 10-year US treasury yield to the German Bund 10-year yield. As the interest rate differential moves in favor of one country, the forward curve of a currency pair shifts.
For example, the current 2-year yield differential between the US and Germany (which is a proxy for European debt) is approximately 85-basis points in favor of the US 2-year yield. This means the US yield is 85-basis points higher. If you plan to buy the EUR/USD and hold it for an extended period you will be paying away yield since you own the euro and are short the US dollar. If you hold it for 2-years and lock in a currency rate, you will pay away 85-basis points.
If the yield differential declines to 60-basis points you will be paying away less and therefore there is less incentive to hold the US dollar. During June the yield differential between the US 10-year yield and the German 10-year yield declined to 101 basis points from 117 basis points making it less attractive to hold the US dollar.
The yield differential that moved against the US dollar was not exclusive to German yields. The Japanese 10-year yield differential against the US dollar also gained traction in June. The differential dropped from 86-basis points at the beginning of June down to 63-basis points by the end of June making the US dollar less attractive relative to the Japanese yen.
One of the reasons the yield differential moved in favor of the Euro was the changing shifts in monetary policy. The dollar has become less attractive as the Federal Reserve worked quickly to dampen the damage created by the spread of the pandemic throughout the United States. The Fed in March of 2020 cut interest rates multiple times and then embarked upon a bond purchase program that was uncapped.
During June the major central banks continued to tweak their monetary policy stimulus. The Federal Reserve’s Main Street facility was launched. The Main Street Lending Program is geared to support lending to small and medium-sized businesses that were impacted by the COVID-19 pandemic. The Program has several components including the Main Street New Loan Facility, the Main Street Priority Loan Facility, and the Main Street Expanded Loan Facility. These programs allow the Fed to purchase loans that banks give to small and mid-sized businesses. The Fed will purchase 95% of each loan.
The Federal Reserve also announced a twist to its corporate bond purchase program. In addition to purchasing corporate bond Exchange Traded Funds (ETS), the Fed announced that it would begin to buy individual bonds in the primary market.
The Bank of Japan announced that it would expand its interest-free lending program to corporations and expand the program to 110 trillion yen from 75 trillion yen. This followed the BOJ’s two-day monetary policy meeting in June.
The European Central Bank also added to its monetary policy stimulus. The ECB created a new three-year loan facility that is approximately 550 billion euros which increased its balance sheet by approximately 10%.
The People’s Bank of China was also active in June. The PBOC announced that it would cut its reverse repo rate by 20 basis points. It also announced a 25 basis point cut in the re-discount rate to 2%, which is geared to assist small businesses.