USD JPY - FUNDAMENTAL DRIVERSUSD
FUNDAMENTAL OUTLOOK: BULLISH
BASELINE
With headline CPI at 8.5%, the Fed is under pressure to continue hiking rates and ramping up QT in September to try and tame price pressures. They hiked rates by 75bsp in July, and odds between a 50bsp and 75bsp in September are too close to call. At the Jackson Hole Symposium they took a further hawkish shift by pushing back against the idea of rate cuts in 2023 by stressing that they not only envision hiking rates to close to 4% by early 2023 but also expect to keep rates high throughout 2023. However, the Fed did announce a data-dependent (meeting-by-meeting) stance at the July meeting, explaining that the pace of hikes is likely to slow as rates get more restrictive and as more data becomes available. This means the incoming growth, inflation and jobs data will be a key driver for short-term USD price action where we expect a cyclical reaction to incoming data (good data being good for the USD and US10Y and bad data being bad for the USD and US10Y ). The USD’s safe haven status is important to keep in mind. Uncomfortably high inflation and a Fed that is resolute and pushing rate higher and keeping them high does put possible further downside pressure on long bonds and equities, and if we see further cyclical-inspired downside in bonds and equities the USD is expected to gain in that environment on safe haven demand.
POSSIBLE BULLISH SURPRISES
With the Fed signalling a data dependent policy stance, we expect a cyclical reaction from the USD with incoming US data. Thus, extremely good growth, inflation or jobs data is expected to trigger short-term bullish reactions in the USD. As the cyclical outlook continues to weaken, the USD’s safe haven status still matters. Any incoming data that exacerbates fears of recession and triggers strong moves lower in risk assets & bonds can trigger safe haven flows into the USD. Any further outflows in US bonds means more USD safe haven appeal. So, watching key triggers for further upside in bond yields (commodity prices, inflation and inflation expectations, more aggressive hike rhetoric from Fed, very good growth data) could also trigger further USD bullish reactions.
POSSIBLE BEARISH SURPRISES
With the Fed signalling a data dependent policy stance, we expect a cyclical reaction from the USD with incoming US data. Thus, extremely bad growth, inflation or jobs data is expected to trigger short-term bearish reactions in the USD. The USD is trading close to cycle highs while aggregate CFTC positioning is close to levels that previously acted as local tops. Positioning does make the USD vulnerable to short-term corrections, especially with bad US data points. With a lot priced in for the Fed and the USD, it won’t take much to disappoint on the dovish side. Any FOMC comments that suggests more concern about growth than inflation could trigger bearish reactions in the USD, but with inflation so high any major dovish pivots seem still far away.
BIGGER PICTURE
The fundamental outlook for the USD remains bullish as long as the Fed stays hawkish and cyclical concerns put pressure on risk assets. The data dependence stance from the Fed means we do want to be mindful that lots has been priced for the USD, and as growth deteriorates (as is currently our expectation), it’s expected to impact the USD negatively in the short-term, even though current inflation suggests any dovish pivot is still far away. As the safe haven of choice, any further recession focused downside in risk assets and bonds (due to sticky inflation and an aggressive Fed) could continue to prove supportive for the USD. In the short-term, with positioning in mind, and a dual-growth narrative (one being good for the USD and the other being bad for the USD) we prefer short-term catalysts that offer short-term sentiment-based trades as opposed to med-term positions.
JPY
FUNDAMENTAL OUTLOOK: BEARISH
BASELINE
In recent weeks, yield differentials have been the biggest negative driver for the JPY with the BoJ keeping 10-year JGB yields capped at 0.25% with yield curve control while other central banks are hiking rates aggressively. Thus, the BoJ’s reluctance to shift on policy even with inflation starting to push higher remains a negative driver for the JPY. Even though the JPY is considered a safe haven, inflows has been limited in the current bear market 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 the bulk of their commodities , so very high energy prices has added to downside. 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. Having said that, US10Y and commodities have been reacting more and more negative to the current negative cyclical growth outlook, and as a result has seen big players trim their massive JPY shorts. But this past week’s push higher in yields was a friendly reminder that inflation and yield differentials remain a major downside risk for the JPY, despite the negative cyclical outlook.
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 fundamental outlook remains bearish for the JPY, especially after the BoJ once again stuck to the same overly dovish script at their July meeting. As long as US10Y remain elevated and the BoJ stays stubbornly dovish and no push back is made against the JPY weakness from the BoJ or MoF, the bias remainslower. But take note of positioning which means we don’t want to chase the JPY lower and bullish reactions can see outsized upside on big drops in US10Y & commodities (which means keeping cyclical developments in the US in mind as a key influence on US10Y and thus the JPY as well). It also means watching incoming CPI data closely as any huge upside surprises could trigger speculation of a possible policy shift.
