Fed Funds Expectations, Inflation and the Dollar

On the heels of the healthy March jobs report and new cyclical highs for both the manufacturing and service sector ISM surveys, the market moved to fully discount a 25 bp rate hike at the Nov FOMC meeting. This was evident in the Fed funds futures strip and the OIS/Fed funds rate. The market has backed off slightly today.

US interest rates have eased today, with coupon yields slipping 3-5 bp, perhaps on some bargain hunting after the 10-year yield reached 4% yesterday. Perhaps Us debt is also picking up a safe haven bid, given the blow out of Greek credits today.

Nevertheless there has been a sharp backing up of US interest rates in recent weeks. There are two components to interest rates. There is the real rates and the inflation premium. In some ways the inflation premium is easier to estimate and the residual would be the real rate.

One estimate of the inflation premium could be derived from the 5-year/5-year forward. Both the Fed and ECB have in the past cited this as one of the measures it looks at for inflation expectations. In the US this rate is now about 2.58%. This represents a little less than a 20 bp increase since late Feb, which was the low point thus far this year. However, that increase seems to be simply noise as the 100-day moving average is near 2.63%. The recent high was set in early Feb just above 2.8%.

By contrast, the US 10-year yield now at 3.94% is well above its 100-day moving average or 3.45%. It appears that the bulk of the increase in nominal US interest rates reflects an increase in real rates rather than the inflation premium. Two considerations seem behind the rise in real yields--supply and stronger growth--and it is difficult to estimate the relative importance of each of these considerations. Subjectively, it would seem like supply is playing a bigger role than increased demand for investment capital.

The US dollar/yen exchange rate is particularly sensitive to interest rate movement. Year-to-date,the correlation (daily percentage change) between US-Japanese 2-year rate differentials and dollar-yen is 65% and the correlation at the 10-year level is about 72%. In 2009, the correlation coefficients stood at .427 and .436 respectively.

Our work does not show a similar relationship between US-German rate differentials and the euro. Indeed, the yen is more correlated with the US-German interest rate differentials than the euro is (US-German 10-year differentials and the dollar-yen are 57% correlated this year vs almost 9% for the euro).

However, in terms of interest rate differentials, the euro appears to have a tighter correlation with the very short-end. We found the euro's correlation with the spread of the second Eurodollar and Euribor contracts (that would now mean the Sept 10 contract) was about 34.5%.