The steady increase in the US two-year yield while the market unwinds rate hike expectations in Australia has pushed the US rate above Australia for the first time since late 2000. In the past month, the US two-year yield has risen by 15 bp, while Australia’s has fallen by 13 bp. But the narrowing of the spread, and now inversion, has been unfolding for the past six years.
Moreover, we suspect there is room for divergence to extend well into 2018. Australia’s case rate stands at 1.5%. With the central bank likely on hold for an extended period, the two-year yield can slip closer to the cash target rate. At the same time, the US two-year yield is trading 50 bp above the upper end of the current Fed funds target and 25 bp above the range expected to be adopted next month. That 25 bp may be a reflection of the one rate hike that the Fed funds futures strip appears to have discounted in full.
What is not priced in is the likelihood of at least two rate hikes next year. We suspect the US two-year yield can rise toward 2.0% and the two-year Australian yield can ease toward 1.50%. The spread, which has just turned in the US favor is likely to continue and could trend toward 50 bp in a coming couple of quarters.
What are the implications for the exchange rate? The Great Graphic posted here shows the rolling 60-day correlation of the two-year interest rate spread and the Australian dollar exchange rate. The correlation shown here is on a purely directional basis. On days the differential increases, the US dollar strengthens the vast majority of times. However, the correlation is not stable, and you can see that in three of the past four years, the correlation snaps and becomes inverted for a short period. Still, as the distribution chart on the right shows that most of the time the correlation is above 0.60.
However, when we conduct the correlations on the level of percentage change, the correlation recently broke down. The 60-day rolling correlation has fallen from a little above 0.5 earlier this month to below 0.2 presently. It is the lowest in a little more than a year. This seems to reflect the fact that after trending since early September, the Australian dollar traded broadly sideways in the first have of November, and then made fresh lows on November 15-21. It recovered following the key reversal on November 21 but posted an outside down day yesterday.
