In recent months there has been a lot of confusion, and loud gnashing of teeth, among the FX trader and analyst community, which has been unable to make sense of the confounding divergence in real spot rate differentials charts between the EUR and USD, whether on the short or long end.

Making matters more confusing has been the sharp jump in the EUR/USD in recent weeks, a paradox in light of the progressively improving US economic data.

And so, traditionally used to trade on correlation pairs, the forex community set forth to find a new, improved, and more accurate correlation between the EUR/USD and… well, anything.  Today, Bank of America appears to have stumbled on the answer in the form of the EUR/USD vs. relative forward interest rate expectations, and specifically the EUR-USD 2y2y-2y forward spread differential.

The reason why this particular forward rate differential is best suited to capture the fate of the EUR/USD is that it looks not at the current pricing of real rates, but future central bank interest rate expectations, especially those of the ECB and BOJ which over the coming year are increasingly expected to slam the breaks on both QE and NIRP.

Here is how Bank of America's FX research team lays out the background:

Pressure on the dollar has intensified in the opening weeks of the year despite a supportive macro backdrop. US data had had a strong run, fiscal stimulus is expected to provide further tailwinds to the already-solid growth outlook this year and the Fed continues to tighten. Yet the synchronized global recovery is focusing market attention on other major central banks. As we have argued before, the USD traditionally benefits from first-mover advantage as the Fed leads other central banks into a global tightening cycle. That was the primary driver of dollar appreciation in 2014-15. However, as other G10 central banks follow the Fed's lead, the USD has been faltering despite ongoing tightening. This is because interest-rate expectations outside of the US have undergone a profound shift. With respect to EURUSD specifically, relative forward interest-rate spreads explain the sustained rise in the exchange rate since early 2017, though upside looks limited for now.

And here is what the relationship looks like in particular, as shown in BofA's “chart of the day”:

Clearly, on a backtest, the 2y2y-2y forward spread captures the EUR/USD moves far more accurately than a simple real spot delta (as seen up top). In other words, instead of using spot rate differentials, the proper metrics is a “forward” based framework for exchange rates.

Here Bank of America explains why spot rate differentials no longer work:

The fundamental link between global central bank repricing and USD-based exchange rates (emphasis: EURUSD) cannot be seen through the traditional lens of spot interest rate differentials, which have broadly continued to move in a direction favorable for the dollar. Indeed, the US two-year swap rate has risen a full 65bp from levels prevailing in early September (for reference, only the CAD 2y rate rose by more).