One very large divergence please (with a dollar chaser) According to Nomura, since 1980, there are only two periods of economic divergence - between the US and Europe and the UK - comparable to what we are observing currently. The first period was in the early 1980s, when the US unemployment rate peaked in December 1982, but the rate in the UK and Eurozone kept rising beyond this point. This allowed the Fed to start a hiking cycle as early as late-1980, while the BOE was still cutting rates until mid-1981. The impact on the currency market was clear as well, with this helping to exacerbate the broad-based USD rally which continued until the Plaza Accord in 1985. The overall broad USD rally from 1978-85 was more than 50% in real terms. The second notable divergence was in the early 1990s. The US economy recovered from the recession faster, while Europe faced the ERM crisis in 1992/1993. This created a sizeable economic divergence, which continued until the early 2000s, in part helped by the TMT boom in the US. This period coincided with another large USD bull-rally (1995-02) of more than 30% in the broad real USD index. The exception to this pattern was in 1994 when the USD was weak vs. G10 countries due to idiosyncratic factors. And that is helping throw the dollar up against both sterling and the euro, with the dollar index having gained 4.5 per cent since mid-June. Rate divergence, based on improving data in the US and on the contagion that is forward guidance on the other of the Atlantic, is obviously a very large part of the reason with Nomura's Jens Nordvig noting that last week "was only the ninth instance of a 30bp+ widening of the 2yr forward short rate spread between the US and Eurozone since the creation of the euro. In addition, the 3-week move of more than 60bp was the second largest since 1999 (only exceeded by a move in 2003) . David Woo at Bank of America Merrill Lynch expects the US to keep up its side of the differential bargain (as Asmussen seemed to do the same over here): Even after the biggest Treasury sell-off in years, we fear the balance of risks continues to point to higher Treasury yields: short positioning is still moderate, yields are not yet at levels that would attract long-term value investors (10y Treasury yields one year forward are still only at just 3%!) and outflows from bond funds will likely continue. We have revised up our 10y Treasury yield forecasts to 3% by end- 2013 and 4% by end-2014. Woo also argues that the negative impact of stronger US growth on the US current account deficit is likely to be more limited than in the past and the positive impact of stronger US growth on the growth of the rest of the world will be also more limited. All of which should make the rates and growth differential between the US and everyone else widen further. But we'd note in the face of seeming consensus that stronger US data doesn't always lead to a stronger dollar (see 2002-2004 for example), and rate divergences have not always produced tradeable signals. From Nordvig again: Figure 1 shows rate spreads vs. EUR; here, the market reverses a decent amount in the four weeks following the divergence in almost all past instances (seven of the past nine). Price action in the currency market is consistent with rates, and EURUSD actually averaged a gain of 1.4% in the following four-week period (see the last row in the table). A similar theme is seen in GBP as well, where rates reverse the move in about half of the instances analyzed (in the next four weeks), and while GBPUSD does sell off on average, the median move in the currency is not significantly different from zero (not shown in the table). Really quite hard to look past it all at the same time, though. Related links: A dollar bully - FT Alphaville Dollar bulls on the charge - FT Trading Post