Fundamental Evaluation Series: EUR/USD vs. yield divergence review

The chart above shows, how the relationship between EUR/USD and 2-year yield divergence has unfolded since 2012. It is evident that these short rates have been a key influencing factor for the pair as policy divergence became evidence since 2013. As the speculations from extraordinary monetary stimulus went crazy since the beginning of 2014, yield divergence between German 2 year bond (considered as European benchmark) and the US 2 year note went from -0.18 percent at the beginning of 2014 to -0.78 percent by the end of the year and EUR/USD declined from 1.367 to 1.2 by year end.

We see further drop in the EUR/USD exchange rate in 2015 as ECB introduced monetary stimulus but the yield failed to follow that fast, it only started declining as expectations over further stimulus grew and by end of December more than 50 basis points compared to first quarter of 2015 but European Central Bank (ECB) disappointed in December and only to deliver in March 2016.

However, since December, Germany-US yield divergence has moved in a range lacking clear direction as Fed became more cautious than expected. So has the EUR/USD.

We expect, the next major move likely to come when either Fed or the ECB will choose to act further on their diverged path, which again will be data dependent.