The linkage between the US interest rate premium over the Euro area and the euro-dollar exchange rate appears to have broken down in the April and May period. However, as this great graphic, composed on Bloomberg, shows, the two have been re-coupled, thanks to both higher US rates and lower German rates.
The white line shows the US-German 2-year spread and the yellow line is the dollar against the euro. Over the past week, the US 2-year yield has risen 6 bp and the German 2-year yield is off 2 bp. Over the past month, the US-2-year yield has risen 4.5 bp and the German yield has fallen 10.5 bp.
Going forward, the spread may be dictated by the performance of the US side of the equation. The German 2-year yield is at 2 bp annualized. In mid-2012, the yield was near -10 bp, but this was a function of the safe haven offered, and a potential call option on a break-up of the monetary union in some fashion, which many had thought was increasingly likely.
With the deposit rate at -10 bp, it is possible that EONIA turns negative by a few basis points in the coming weeks. The German 2-year could also dip into negative territory as banks push funds further out on the curve. The ECB reports that Euro area banks have reduced their use of the deposit facility to its lowest level in around three years yesterday as the negative deposit rate came into effect. Note that the negative deposit rate applies to a range of accounts at the ECB and is not limited to the deposit facility.
The effects of last week's ECB announcements are only beginning to be seen. Next week, for example, it will not seek to sterilize the SMP purchases and help maintain high levels of liquidity and a soft EONIA, which has now fallen below the effective Fed funds rate for the first time since Q4 13.