[Jason_Lim]

Looking at the relationship between moves in G10 currencies and moves in their 2-year swap rates as a simple proxy shows just how strong this connection has been. Simple cross-sectional regressions make the point clearly. The most basic variant looks at the shifts in swap rates since March when the equity rally began and since early July with G10 FX versus the USD. There is a nearly 90% correlation in the cross-section over both time periods, with much greater strength in those currencies where rates have risen over that time frame (Sweden, Australia, Norway, New Zealand, Canada) relative to those where they have fallen (Eurozone, UK, Switzerland, Japan).

There is some evidence that those with higher rates (not just rising rates) also performed better (ie that carry was rewarded in spot too) but including both in a regression it is clear that it is the change in rates that mattered more. The magnitude of the relationships is also large. For every 100bp shift in the 2-year rate across countries, there has been an associated 10% move in the currency.

What these simple regressions also suggest is that alongside the impact of rates, there has been an independent pressure for USD weakness over that period.

The basic story is very simple. Positioning for those who are likely to tighten early in G10 and are likely to prove more aggressive than the market thinks versus those who are likely to be later is a strategy that is on average proving highly rewarding.

Last week’s surprise Australian rate hike was revealing in several ways. First, it illustrated (as during the easing cycle) that even long after the signal that a shift to tightening has occurred, there is room for the currencies (and rate contracts) to continue to move. The market has been confident that a rate hike is coming since the Q2 GDP release on September 2. But since then, the AUD TWI is up over 6%, the AUD/USD rate is up 8% and 2-year swaps have sold off by a further 30bp. So the market can still be surprised by the speed of the shift to tightening even where it is clear that it lies ahead.

Second, basing investment strategies entirely on what central banks are saying can be very risky around turning points. The market was pricing cuts in Australia as recently as June (even, incredibly, as it was pricing a fairly concrete November rate hike in the US) and as recently as July, the central bank sounded like it had a firm easing bias, although the underlying macro picture was already improving quickly by then. Central banks know that they will tighten financial conditions at the first point at which they signal a change in tack and so may not shift until they are ready to act soon. With the market paying a lot of attention to central bank dovishness from Canada to Sweden to the UK to New Zealand, it is important to stay very focused on the outlook and the data not the rhetoric. Last week’s Canadian data has begun the challenge to the BOC stance. Third, FX markets are proving very responsive to these shifts. Although it may be true at some point that stronger currencies will act as a substitute for higher rates and deter central banks from tightening (both Canada and New Zealand have made noises of this kind), the two are strongly positively correlated in the G10.