Divergent yield curves

We can compare the movements of different yield curves across different maturity segments via the forward rate ratio (FRR) between six and nine months. This is the rate at which we can borrow for three months starting six months from now, divided by the nine-month rate.

Any threat to end quantitative easing in Japan should affect the FRR along the money-market curve, especially the six-to-nine month segment. This, indeed, occurred in November at the time yen option volatility began to rise.

This FRR began a climb that accelerated on Feb. 3, the same date at which the yuan’s climb against the dollar began to accelerate. This steepening was accompanied by a flattening of the FRR between the three-month yen LIBOR rate and 10-year U.S. Treasury yields. As the JPY six-to-nine month yield curve steepened, indicating expectations for short-term rate hikes in Japan, the yen carry curve flattened even as U.S. rates rose. The carry curve between the three-month yen LIBOR and 10-year U.S. Treasuries is still greater than 1.00, confirming this trade is still profitable. The high JPY option volatility confirms traders are buying insurance against the trade’s principal risk, future JPY strength.

It is critical to note just how little the yen carry trade affects the course of U.S. 10-year notes. The yen carry trade’s FRR flattened rapidly after Feb. 3, and while 10-year note yields rose after that point, it is important to note they had been rising irregularly for some time. It would be difficult to ascribe causality to the yen carry trade in the short-term.

More important, however, is a correlation reversal around Feb. 3. Prior to this date a wider FRR and 10-year note yields were correlated positively. Between Feb. 3 and March 24, also marked on the chart, the correlation became negative. The period after Feb. 3, as we have seen, is associated with both an acceleration in the CNY’s strength and with a rapidly declining yen carry. As the CNY strengthened, Japanese short-term rates rose faster than U.S. long-term rates.

Fundamental economic relationships do not reverse on a whim. Which side of Feb. 3 is the correct one? The answer, as we shall see shortly, depends on the outlook for the JPY/CNY exchange rate.

Before we delve off into this important cross rate, let’s take one final parting shot at the yen carry trade’s importance to U.S. Treasury yields. In the long-term, connections between the yen carry trade and 10-year note yields collapse altogether. We can extend the analysis back to 1989 and observe how very low levels of carry in the late 80s and early 90s corresponded with rapidly falling U.S. yields and how very high levels of carry did not prevent a general increase in yields after September 2003. The two series are virtually unrelated.