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FED’s Dilemma, JPY Strength and USD

Yesterday’s release of US data once again illustrated the Fed’s dilemma. Industrial production showing solid gains stood against disappointing CPI data. Headline CPI slowing from 1.0% to 0.8% and core inflation from 2.3% to 2.2% supports our view that disinflationary forces are at work globally. An analysis of local output gaps and related estimates of an early pickup of inflation have been misleading so far. The FX impact of this US data suggests there is further downside for the USD for now. Today markets will focus on the FOMC minutes, with any hawkish tilt providing USD selling opportunities.

There is important information for equity investors from the recent rise of US real yields. It has been the lower real yield level that has provided the equity market with a boost. Shares rose primarily due to high bond market valuations and not due to a better earnings outlook. Sure, Q2 earnings beat expectations but corporates have been lowering the expectation bar for some time now. Companies have been finding it increasingly difficult to boost net earnings due to a generally weakening top line and using cost cutting programs where most of the easy implementation had been completed some time ago. Moreover, increasing the return of equity via replacing equity with debt has weakened balance sheets and no longer guarantees a positive share price response. For instance, the US index comprising companies involved in own share buybacks no longer outperforms broader indices. All these findings support the view that real rates may have to stay low to keep the equity market and, implicitly, US financial conditions underpinned.
An early Fed rate hike pushing US real rates up will not bode well for risk appetite and related financial conditions. An economy with high leverage and low returns of investment requires real rates to stay low to avoid a growth outlook damaging appreciation of real debt. The Fed’s Dudley accompanied by overnight comments from Lockhart keeping the door open for a rate hike in September or December try to keep the Fed with optionality. However, given the relationship between real rates, the equity market and financial conditions, we believe the Fed may constrain itself from hiking early. If the Fed does not constrain itself, any USD rally will find its limits in a subsequent decline of financial conditions and the Fed moderating its rhetoric once again.

Against this backdrop USDJPY has more downside potential. Verbal intervention by Japan’s MoF’s Asakawa should not help USDJPY for long. Should the Fed’s hawkish rhetoric drive real rates higher, risk markets are unlikely to withstand this pressures, providing a repatriation bid for the JPY. An additional factor suggesting a lower USDJPY is the rise of the US LIBOR rate due to regulatory changes. Japan’s corporate and financial sector has used the US Prime money market for funding. The increased cost of this funding tool suggests these companies may use JPY over USD funding. A similar constellation plays in for the EUR. The chart below shows that Japan’s life insurance companies have generally FX hedged a higher proportion of their EUR assets relative to USD assets, suggesting that need to hedge existing EUR asset positions is less and so adds to our EUR bullish views.
Sterling is unlikely to hold onto post inflation related gain.The BoE has made it clear that it can tolerate an inflation over shoot and will remain very accommodative, supporting our 1.24 target for GBPUSD. The BoE was successful in purchasing long end gilts yesterday, providing the market with increased credibility that the programme can work. Any further downside pressure on gilt yields from the QE programme will add to currency weakness. It is not only nominal UK yields in decline, the rising inflation print has added further down sidefor real yields too, which are currently running against rising US real yields, keeping GBPUSD weak.


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