As we have said before, yields are major drivers of FX at the moment, especially for USDCHF, EURUSD and GBPUSD.

The charts below show the close yield/ FX relationships:

EURUSD (yellow line) and 3-month euro swap rates:



GBPUSD (orange line) and 3-month GBP swap rates


10-yr Treasury yields and USDCHF (orange line)


However, USDJPY hasn't followed suit and has remained fairly range bound although 2-year US Treasury yields have spiked higher recently (USDJPY and 2-yr yields tend to have a strong positive correlation). The yield/ FX theme is not driving this pair. One reason for this is that 2-year Japanese yields have also spiked higher in recent weeks, which is acting as a floor for the yen.



Euro: the euro is following swap rates extremely closely. Rates have come off recently, which has been accompanied by EURUSD coming off its 1.3800 highs. But yields are still strong enough to lend support to the single currency. The ECB might not be on the cusp of hiking rates but they are likely to hike possibly this summer. The ECB has voiced its concerns about price stability and the German contingent in the ECB is very inflation- focused. Thus, bar another shock from the sovereign debt crisis (like Spain needing a bailout), swap rates should remain supported and the EURUSD should continue to trade with a bullish tone, although the pace of gains especially above 1.3800 and towards 1.4000 may slow as the prospect of ECB hikes get pushed out to the future.

Pound: Interest rate expectations in the UK have reached fever-pitch and are over-extended in our opinion. The market is pricing more basis points of hikes for the UK than any other G10 country. But the growth outlook in the UK is still unclear, economic data statistics have been all over the place and although headline inflation is elevated, the BOE is less concerned about this than the ECB. As long as inflation concerns don't spill over to wages, which they haven't done so far (wage growth is still negative in real terms in the UK) then there is less of an immediate need for the BOE to hike. Also, the stronger tone to sterling recently has arguably done some of the tightening for them. This leaves swap rates at risk of a reversal and thus the pound also vulnerable. While we think the pound will remain range bound for the next few days, next week's Inflation Report is a major event risk for sterling. If King sounds dovish or hints that the market has got ahead of itself regarding rate increases then we could see a swift move lower in the pound. If we break below 1.6005 - then we could see back to 1.5875 lows.

Dollar: Although yields have come off their highs, the long-term range in 10-yr Treasury yields has been broken, which suggests a stronger dollar, especially versus the Swiss franc. The Swiss authorities look less likely to raise rates, and even though the Fed is unlikely to hike rates anytime soon, the fall in Swiss 2-year yields is driving USDCHF higher.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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