After U.S. Federal Reserve officials signaled an upcoming interest rate hike, the Fed Funds Futures market did not wait for reports from the U.S. labor market. Already by mid-week, the market was anticipating a 100 percent chance of a 25 basis-point rate hike at next week's meeting of the Federal Open Market Committee. The U.S. 10-year Treasury yield also climbed to its highest level this year, close to 2.60 percent.

In the U.S., markets are focused on whether there will be two or three rate hikes this year. But internationally, higher U.S. Treasury yields are affecting other countries' government bond yields and perhaps their currency values as well. Focus is shifting from short-term interest rates to long-term yields.

In Europe, yields on the German 10-year Bund, the equivalent of the U.S. Treasury bond, have risen in the same magnitude as U.S. 10-year Treasury yields. While the president of the European Central Bank, Mario Draghi, is known as a dove, there are hawks within the ECB who want to end quantitative easing sooner than later.

Eurozone inflation is at 2 percent, which is their target. Given ECB's mandate of controlling inflation only (rather than having a dual mandate that includes full employment, such as our Fed has), this is justified. However, the hesitation to end quantitative easing is pretty straightforward:

  • German inflation is at 2.2 percent but other eurozone countries are not as high
  • Political risks from upcoming elections in France, the Netherlands and Germany are putting the ECB in a wait-and-see mode
  • The risk of moving too early in raising rates is viewed as larger than moving too slowly

Consequently, short-term interest rates in Europe have not gone up but the bond market is reflecting the rising inflation picture.

In Japan, the 10-year Japanese Government Bond (JGB) yields are trying to rise but have been suppressed. Japan is starting to see some rise in inflation with a cheaper yen and higher oil prices. Bank of Japan Board Member Takako Masai was quoted this week as saying that Japan is no longer in a state of sustained deflation.

What keeps JGB yields from rising further is the policy of the BOJ to target the 10-year JGB yield at “close to 0 percent." Consequently, BOJ continues to buy JGBs when the yield rises too high.

My View: Bund yields rising higher than JGB yields explains why the yen has weakened more than the euro. This trend may continue until the BOJ loosens its grip and allows for a further steepening of their yield curve, which would allow JGB yields to rise a bit more. Until then, we may see a period of more yen weakness than euro weakness.

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