EUR JPY - FUNDAMENTAL DRIVERSEUR
FUNDAMENTAL OUTLOOK: WEAK BEARISH
BASELINE
In recent weeks, the persistently high inflation has seen the ECB take a more hawkish turn with the bank confirming at least a 25bsp hike for July and possibility of a 50bsp hike in September. Despite the hawkish policy shift, the concerns over fragmentation in bond spreads (BTP\Bund) as well as fears of growing stagflation risks has seen the EUR struggle to hold onto any hawkish ECB momentum. The ECB did try to comfort spread concerns with promises of a new fragmentation tool, and even though it has kept spreads from widening further, concerns remain. If the bank can convince markets that their new spread tool(s) can stop fragmentation it should be supportive for the EUR. However, with a material energy crisis facing the EZ due to the war in Ukraine, the economic prospects look bleak. Even though growth data was surprisingly resilient in Q2, fresh recession fears ramped up as recent forward-looking growth data surprised materially lower for key members like Germany and France. Based on the forward-looking signals from leading indicators we think recession is likely in the EZ and that the narrative has turned more bearish for the EUR until that improves.
POSSIBLE BULLISH SURPRISES
Geopolitics remains a focus, and any possible de-escalation or cease fire in Ukraine would open up a lot of EUR upside. Also keep Italian politics in mind where any successful attempt by PM Draghi to stay in power should ease spread concerns. Stagflation fears are high, with growth expected to slow while inflation stays high. Recent PMI data has invigorated recession fears, which means any materially better-than-expected growth data (Flash PMIs this week) could spark upside. Even though the ECB’s recent communication has been enough to push BTP/ Bund spreads from their recent highs the concerns remain, especially with Italian politics further exacerbating the problem. Thus, any insights or clarity regarding their new tool that convinces markets it can solve fragmentation should be supportive for the EUR. Energy concerns are still in focus, which means watching the Nord Stream 1 pipeline closely, if Russia resumes gas flows after maintenance ends this week it could see EUR upside.
POSSIBLE BEARISH SURPRISES
Geopolitics remain in focus, any escalation in the Ukraine war that risks including NATO would be big negative risks. Also keep Italian politics in mind, where any triggers of general elections risk further spread concerns & pressure the EUR. Spread fragmentation remains in focus, and if the ECB fail to calm fears or even walks back on recent hawkish comments it could trigger bearish reactions in the EUR. Growth concerns continue weighing on the EUR and means incoming growth data (Flash PMIs this week) will be in focus, where any major negative surprises could trigger downside. We've seen a chunky repricing in hike expectations over the past three weeks, and any further lower repricing is expected to weigh on the EUR. Energy concerns are still in focus, which means watching the Nord Stream 1 pipeline closely, if Russia keeps gas flows closed after maintenance ends this week it could see EUR downside.
BIGGER PICTURE
The fundamental outlook for the EUR has shifted to bearish with recent leading indicators pointing to a much faster economic slowdown than markets had previously expected. There are bearish and bullish factors in play right now though. On the bearish side we have geopolitics, stagflation, spread fragmentation and energy concerns acting as negative drivers. But we also have hawkish ECB policy as a possible supportive driver. Recession risks does open up a narrative change for the EUR which will require markets to change their forecasts to reflect higher recession risks which should continue to weigh on the EUR.
JPY
FUNDAMENTAL OUTLOOK: BEARISH
BASELINE
The Yen has seen a lot of depreciation this year driven by very negative fundamentals. Yield differentials has by far had the biggest negative impact. With other major central banks starting aggressive hiking cycles, it has lifted yields quite dramatically, which has seen yields like US10Y push considerably higher than 10-year Japanese yields capped at 0.25% by yield curve control. That means dovish monetary policy remains a key negative driver. Despite inflation starting to push higher in Japan, and despite the lessons from other central banks now struggling with inflation last seen since the 70’s, the bank has once again at their June meeting stayed stubbornly dovish keeping yields capped at 0.25%. At this stage the bank is playing a very dangerous game by allowing the JPY to weaken, further adding to inflationary risks. Their dovish persistence remains a negative for the JPY. Even though the JPY is considered a safe haven, inflows has been limited compared to other cycles. The reason is Japan’s current account surplus (a main reason for safe haven appeal) has deteriorated due to the rise in commodity prices. Japan imports over 90% of their energy commodities, so continued rise in oil prices has added to downside and eroded some safe haven appeal. The BoJ and MoF’s reluctance to intervene to stop the rapid depreciation in the JPY in recent weeks has been noticeable. As long as they just voice their dislike but fail to act, the market will keep testing them and shorting the JPY.
POSSIBLE BULLISH SURPRISES
Catalyst that triggers speculation that the BoJ could drop YCC or hike rates or both (big upside surprises in inflation) could trigger upside in JPY, which means inflation data will be important to keep on the radar. Catalysts that trigger meaningful corrections in US10Y (less hawkish Fed, faster deceleration in US inflation, faster deceleration in US growth) or meaningful bouts of risk off sentiment could trigger bullish reactions from the JPY. Any catalyst that triggers meaningful downside in key commodities like Oil (deteriorating demand outlook, ease in supply shortage) could trigger bullish JPY reactions. Any intervention from the BoJ or MoF to stop JPY depreciation (buying the JPY or giving firm and clear lines in the sand for USDJPY) could offer decent reprieve for the JPY.
POSSIBLE BEARISH SURPRISES
With yield differentials playing such a huge role for the JPY, any catalysts that push US10Y higher (more aggressive Fed, further acceleration in US inflation, better-than-expected US growth data) could trigger further bearish price action for the JPY. Any catalyst that creates further upside in oil prices (further supply concerns, geopolitical tensions) poses downside risks for Japan’s current account surplus and could trigger further bearish reactions in the JPY. Further reluctance from the BoJ and MoF to address the concerning depreciation in the JPY, and further reluctance from the BoJ to pivot away from very dovish policy is a continued negative driver for the JPY to keep on the radar. If the BoJ pushes back against calls for a policy shift despite upside surprise in CPI could trigger further JPY downside.
BIGGER PICTURE
The bigger picture remains bleak for the JPY, especially after the BoJ once again stuck to the same overly dovish script at their June meeting. As long as US10Y gains ground and as long as the BoJ stays stubbornly dovish and no push back is made against the JPY weakness from the BoJ or MoF, the bias remains lower. Take note that positioning has been stretched (tactically and CFTC) for some time, which means we don’t want to chase the JPY lower and bullish reactions can see outsized upside. It also means watching incoming CPI data closely as any huge upside surprises could trigger speculation of a possible policy shift.
