Carry Trades Still Supported, JPY weakness and EURUSD
JPY and EUR funded carry themes stay on top of our recommendation list. The resignation of the Fed’s Tarullo, responsible for bank regulation, will add to speculation that the US banking sector is soon going to be in a position to increase its higher risk assets, which will be seen as market risk friendly. This morning has seen copper prices in China rallying by as much as 5.9%, inspired by disruptions in mines in Indonesia and Chile and strong demand in China. Oil has continued its rally, supported by last week’s IEA report which suggested 90% compliance with the OPEC output cuts agreed. Higher commodity prices will steepen curves within output gap closed economies such as the US adding to USD support against low yielding currencies. In this scenario, EM should stay bid across the board helped by better revenue prospects on the back of higher commodity prices.
TheJPY5_30’s curve has flattened for the 4th day in a row underlining the success of the BoJ’s yield curve management. Today’s release of strong 4Q GDP growth (1%QoQ) provided probably the best outcome for the JPY to weaken further. It was strong enough to keep inflation expectations high enough to keep JPY real yields contained. On the other hand it was weak enough to still keep the BoJ on its yield curve managing approach. The technical position of USDJPY looks bullish leaving markets taking advantage of the benign outcome of the Trump Abe meeting this weekend in Florida. Underlining both countries’ common geo Pacific interests should imply that the US has an interest in a strong and reflating Japan. For Japan to reflate it needs yield curve management leading to JPY weakness, within a globally reflating environment.
The only risk to JPY weakness may come out of Europe where Japan holds significant holdings in semi core sovereign bonds. There is a lot of talk about political risks in the run-up to the 15 March election in the Netherlands, the April/May French Presidential election and the September General vote in Germany. However, economic and credit concerns may be even more important. The hawkish speech by the ECB’s Mersch on Friday does not lead to EUR strength. Instead it revealed EMU’s structural weakness suggesting EURUSD may break the 1.0610 chart point. Should the ECB talk tough and Italy stay economically weak then EMU real rates will be too high for Italy, suggesting the BTP spread will widen out.
In recent days the EUR has become negatively correlated with peripheral spreads. Japanese investors holding semi core bonds may become increasingly concerned seeing core EMU bond curves steepening with peripheral bonds undergoing a bearish credit driven flattening. In comparison to the JPY, the EUR may be the better short. Greek debt worries have come in and out of focus for EUR investors. Greece has a EUR1.8bln payment to the ECB in April and 7bln to creditors in July. Should the IMFstick with its principles (Europe is no longer the main shareholder) then there must be a new package negotiated. Since debt relief is unlikely ahead of the German election, the downside for the EUR is significant for us.
European corporate tax in focus. The rejection of the Swiss corporate tax reform via Sunday’s referendum shows how deeply rooted populism has become, now affecting even rich countries. The CHF should say strong despite concerns of reduced corporate inflow. The main FX takeaway from this story however is its contribution to the Brexit negotiations. There have already been suggestions that the UK could cut corporate tax rates if the EU fails to provide it with an agreement on EU market access, therefore the Swiss tax complications and the uncertainty-induced potential for corporate rates to stay low there could work in the UK’s favour. EURGBP shorts are making more sense now as a medium term trade, with a move below the 200DMA at 0.845 providing more downside momentum.