Follow the Yield

The defining action this weekend had traders basing their decisions almost entirely on yield differentials between countries.  In many cases, broad economic data was ignored in favor or inflation expectations and interest rates.  That’s why it is so important for foreign exchange traders to study the futures charts and determine which central banks the market thinks are likely to raise interest rates.  Example number one is the state of the US dollar.  Friday’s CPI report drove the market for the dollar.  Core prices rose only 0.1% in May, signaling that inflationary pressures were under control and in line with the growing economy.  As such traders in the forex market see no reason for interest rate hikes in the near future, and the dollar has suffered as a result.

The Japanese yen and the Swiss franc have also fared poorly in the currency market mainly due to interest rates.  The economic situation in Japan and Switzerland is completely different.  The Swiss economy is robust and growing at a rapid pace, while the Japanese economy, despite satisfactory GDP growth, still has to contend with weak consumer demand.  Yet both currencies are experiencing a similar freefall; low interest rates in both Japan and Switzerland make carry trading especially attractive.   The Bank of Japan not only did not raise rates in their meeting last week, but its comments suggested that it was unlikely to raise rates next time either unless consumer demand picked up.  The Japanese economy is simply not ready for interest rate hikes.   In Switzerland, despite much stronger economic data, the SNB chose to only raise rates by 25 basis points.  This did not do nearly enough to cut the rate differential between the franc and the other European currencies.

The situation is only exacerbated by the possibility of interest rate hikes by both the Bank of England and the European Central Bank.  The currency market is loading up on both the pound and the Euro in anticipation of in anticipation of those future rate hikes.  Hawkish comments about inflationary pressures by European Central Bank council members continue to bid up support for the Euro (EUR/USD at highest in two months) despite poor Industrial Production and Retail Sales data.  In England, BoE Governor Mervyn King is as hawkish as ever concerning rising inflation.  The likelihood of rate hikes is being priced into both currencies, leading to gains across the board, especially against the US dollar, Japanese yen and Swiss franc.