A wider yield spread signals a higher return on investments in one country than another, driving capital inflows and affecting exchange rates. Looking at the difference in yields between the German 10-year government bond and the US 10-year Treasury note, there is a clear opportunity for traders to take advantage of the yield differential. The current yield on German 10-year government bonds is 2.44%, while the benchmark US Treasury yield is 4.44%, leaving an interest rate differential of near 200 bps. This significant difference in returns means investors are drawn into the US market, increasing the demand for the US currency and strengthening it against lower-yielding currencies such as the EUR.
Figure 1 shows a clear correlation between the EUR-USD currency pair and the yield spread, where the widening spread in favour of US Treasuries, resulting from a growing rate cut expectations in the Eurozone compared to the US, is weighing on the EUR against the USD. According to Fed Funds Futures, the market had priced in five full rate cuts with a high probability of a sixth at the beginning of February; however, the expectations have been reduced significantly to less than three 25 bps currently. For the Eurozone, the market has ramped up expectations for rate cuts and is currently pricing in around four by the end of the year.
This is also reflected in the speculative currency futures market. For the week ending March 26, speculators on the USD increased net bullish positions, bringing net long positioning on the US dollar to $13.53bn, compared to -$1.04bn at the start of February. Investors have shifted from a bearish dollar outlook to a bullish stance due to the monetary policy divergence expected between the two central banks.
The yield differential in Figure 1 has shown a significant widening in favour of US yields since March 2023. The relationship between this yield differential and the EUR-USD currency pair is evident, and as the spread travels further into negative territory, the EUR is expected to weaken further against the USD.
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