FXStreet (Delhi) – Sebastien Galy, Macro strategist at Deutsche Bank, suggests that even though the rates market prices in the forward path of the Fed, we find that EUR/USD ignores it and prices it only as a function of the yield differential. Key Quotes “We find that a 1% drop in the yield differential leads to a 10 to 15 big figure drop in EUR/USD. If expectations of Fed tightening only increase at the pace priced into the forward rate, it should drive EUR/USD lower as the market trades it as a function of the 2 year sovereign spread and not its forward path.” “If in addition, the Fed’s dot forecast is anywhere close to correct the move in both yields and the USD would be theoretically considerable as EUR/USD drops 15 to 20 big figures for a 1% drop in the rate differential.” “We find that the FX market trades EUR/USD as a proxy for 2Y sovereign rate differentials far more so than any other maturity. The significance of the 2Y spread is quite robust to a variety of models, time periods and frequencies from daily, to monthly and quarterly. The forward path of the two year on the other hand proves at best of secondary importance and is rarely statistically significant.” “Based on the current pricing of the relative forwards, EUR/USD is set to slowly drift lower over the next few years. A more probable scenario is that the market moves somewhat towards the path projected by the Fed. A 1% drop in the EU/US 2Y spread differential would drive EUR/USD 15 to 20 big figures lower depending on the methodology. Taking this result at face value with its consequent deflationary impact, it is unlikely the Fed would reach its neutral rate of 3.375% by 2018 as it projects.” “We have seen early signs of the damage a strong USD can do. With corporates struggling for growth opportunities abroad, they must seek more productive use of their labor, keeping wage pressures well contained in the US even as the labor market tightens. At the same time, a strong USD does support US consumption. The combination of a resilient consumer and a gently tightening Fed leaves the USD appreciating by default as the ECB eases carefully in line with its mandate.” For more information, read our latest forex news.