The evolution of exchange rates can depend on many factors: monetary policy, inflation, the trade balance or current account, capital flows, central bank credibility etc. High on the list of the drivers used by practitioners is the nominal long term bond yield differential. It is a narrow and imperfect indicator. Though one can argue that it incorporates monetary policy expectations, it doesn’t take into account that high nominal yields can simply be a compensation for high expected inflation and as such should not warrant a stronger currency.

The chart shows a scatter plot of changes in the spread between 10 year German government bond yields and 10 year US treasury yields on the one hand and the change in the value of the euro against the US dollar. Data are monthly and start in 2000.

 EUR USD

 The chart shows three things:

  1. There seems to be a positive relationship (as one would expect)
  2. There are many observations where the relationship has the wrong sign (the southeastern and northwestern parts of the chart)
  3. Over the past 12 months the hit rate has been high: the red dots predominantly show a relationship with the correct sign (rising US yields compared to Germany being accompanied by a weakening of the euro against the dollar).

If the recent experience provides any guidance for the future, formulating a view on the outlook of the EURUSD hence requires focusing on where respective bond yields will be going.