USD JPY - FUNDAMENTAL DRIVERSUSD
FUNDAMENTAL OUTLOOK: BULLISH
BASELINE
Hawkish Fed policy remains a key driver for Dollar strength. With headline inflation >9%, the Fed has been pressured to tighten policy aggressively, hiking rates by 75bsp at their June meeting, and continuing with Quantitative Tightening. However, as a result of increasing fears of a growth slowdown (as evidenced by recent econ data), STIR markets have repriced lower, and now expects a terminal rate of 3.5% (versus >4% before the June FOMC meeting). Even though lower STIR pricing should be negative for the USD, the growth concerns has sparked further risk off concerns and have seen safe haven flows into the USD. The USD is usually inversely correlated to the global economy and trade, appreciating when growth & inflation slows and depreciates when growth & inflation accelerates. Further expectations of a cyclical slowdown and continued tight monetary policy expectations has seen investors shun risk assets and even bonds (usually considered a safe haven), and the USD has been a key benefactor of the rush to safety in recent weeks. The current high inflation has meant that bonds have not been sought as a safe haven with a strong stock-to-bond correlation, and this has caused big bond outflows. With bonds not fulfilling its usual save haven role the USD has been the haven of choice. The bias remains bullish , but with stretched tactical and CFTC positioning we don’t want to chase the USD higher right now.
POSSIBLE BULLISH SURPRISES
As aggressive Fed policy has been supporting the USD, any incoming data that sparks further aggressive hike expectations, or comments from the FOMC that signals even more aggressive policy could trigger bullish reactions. As the cyclical outlook continues to weaken, the USD’s safe haven status matters. Any incoming data that exacerbates fears of recession and triggers a big flush in risk assets and triggers a rush to safety should be positive for the USD. Further outflows in US bonds means more USD safe haven appeal. So, watching key triggers for further upside in bond yields like rising commodity prices, rising inflation expectations and upside surprises in inflation data could also trigger further USD bullish reactions.
POSSIBLE BEARISH SURPRISES
Even though the USD has been trading like a safe haven, the worse growth data continues to get, the higher the likelihood of a ‘Fed Put’ in the months ahead. Thus, extremely bad growth data could trigger short-term bearish reactions in the USD. The USD is trading close to cycle highs while aggregate CFTC positioning is close to prior highs which acted as local tops. Thus, stretched positioning could make the USD vulnerable to short-term mean reversion, but finding strong enough bearish catalysts has been tricky recently. With a lot already priced for the Fed, it won’t take much to disappoint on the dovish side. Any FOMC comments that suggests more concern about the economy than inflation could trigger bearish reactions in the USD, but with inflation so high any major dovish pivots seem unlikely for now.
BIGGER PICTURE
The fundamental outlook for the USD remains bullish as long as the Fed stays aggressive and cyclical concerns put pressure on risk assets. But we want to be mindful that lots has been priced for the USD, and as growth deteriorates, it could start to weigh on the USD if markets start pricing in a ‘Fed Put’, even though current inflation suggests any dovish pivot seems a while away. Also, as the safe haven of choice any further recession focused downside in risk assets could continue to prove supportive for the USD. In the short-term though, with positioning in mind, we prefer much deeper pullbacks for new med-term USD longs and would look for short-term catalysts that offer short-term bearish sentiment-based trades.
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, the BoJ once again stayed very dovish at their July meeting. 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 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, if US10Y and commodities start reacting more negatively to the currency negative cyclical growth outlook it could ease a lot of the JPY’s pressure and given positioning could see some sizeable upside in the short-term.
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 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. 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 . It also means watching incoming CPI data closely as any huge upside surprises could trigger speculation of a possible policy shift.
