Rate differentials are less of a factor
In the past couple weeks, Morgan Stanley has been making a case that interest rate differentials don't matter for FX like they used to. Or that the FX market isn't as focused on them as it has been in recent years. Instead, they argue that expectations of growth and flows into equities are more important drivers.
They note that falling US Treasury yields haven't hurt the dollar and that a narrowing of the gap between Treasuries and bunds hasn't had a visible effect. If anything, the euro has fallen in spite of the fundamental change.
From Morgan Stanley:
It seems that real yields have had little influence on EURUSD recently - building on a theme where real yields are losing their explanatory power for FX. The common theme seems to have been that German nominal yields and EURUSD have both been falling, but the underlying driver of the fall - be it inflation compensation or real rates - is less important. Thus, barring a shift in relationship, it seems we need to see the German 10y nominal yield to begin to rise. As we noted previously, FX is increasingly explained by growth differentials, not rate differentials. Thus, we should watch the 10y yield closely as a gauge of market expectations for a growth rebound - which would conceivably both support reflation as well as real growth rates.
I would argue that sometimes correlations disconnect before a sea change in market sentiment. The period immediately before the financial crisis was filled with examples where correlations completely disconnected and nothing made sense.
For this week, they like buying EUR/NZD with a target of 1.72.
