Updated: 06-18-2018

What a Differential a Day Makes
Updated: 14-Jun-18  04:57PM ET
Analyst: Pat O'Hare

It's the summer of 2018, and if things pan out the way the European Central Bank (ECB) expects them to, the key ECB policy rates will be the same this time next year and even a little longer after that.

That was the word anyway from the ECB, which said coming out of its June Governing Council meeting that it "...expects the key ECB interest rates to remain at their present levels at least through the summer of 2019 and in any case for as long as necessary to ensure that the evolution of inflation remains aligned with the current expectations of a sustained adjustment path."

Those key interest rates stand at 0.00% for the main refinancing operations, 0.25% for the marginal lending facility, and -0.40% for the deposit facility.

For benchmark purposes, the target range for the fed funds rate is 1.75% to 2.00%, but if the median rate-hike projection is right, the Federal Reserve will raise the fed funds rate two more times before this year is done, leaving it in the range of 2.25% to 2.50%.

Why does this matter? Because it is the foundation for why the U.S. Treasury market is apt to get the benefit of an interest-rate differential trade at least through the summer of 2019.

Granted we might be getting ahead of ourselves, yet there is a basis to think that a curve flattening trade will persist as rates at the short end of the yield curve rise faster than rates at the back end of the yield curve.

Market participants got a taste of that dynamic on the day of the ECB announcement, which came one day after the Fed announcement. The yield on the 2-yr note rose two basis points to 2.58% while the yield on the 10-yr note dropped three basis points to 2.95%.

What was even more remarkable about the move at the back end is that it occurred despite a Retail Sales report for May that was stronger than expected and an initial jobless claims report that showed continuing jobless claims falling to their lowest level since December 1, 1973.

In other words, there was an ample economic basis to drive long-term yields higher, yet they followed a counter-intuitive path due to an interest-rate differential trade that was induced by the ECB's dovish-minded rate stance.

It's a thought that will need to be filed away, particularly if the yield curve ends up inverting in what just might be a false economic signal.

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