The currency hedged return of new USD denominated US Treasury investments no longer bears a yield advantage when compared to Bunds, suggesting European demand for US bonds may abate somewhat from here. Everything equal US bond yields may find it more difficult to print lower bond yields. Yesterday, oil markets rallied by 3.1%, but for very little fundamental reason. This tells us that this rally should be viewed in the context of the 20% decline in oil prices from their June highs; i.e. a technical correction with limited scope to the upside due to the continued supply overhang. Should oil markets stay under medium-term selling pressure and the foreign inflow into the US bond market slow down from here then the US equity market and implicitly US financial conditions may come under additional pressure with rising real US yields working as the catalyst.
Japan’s weekly security flow data released this morning showed that Japan’s appetite for foreign currency denominated bonds (we assume largely the USD) has eased too (JPY312bn after peaking at JPY2549bn at the start of July). Instead, foreign accounts have piled into the JGB market and particularly into JPY denominated money market instruments (total: JPY 2.2trn) which either signal markets turning into risk aversion, raising expectations of a stronger JPY, or central banks reallocating reserves into the still underweighted JPY. Whatever the reason, the finding is JPY bullish. Deputy Governor Iwata’s overnight commentary leaving the impression the BoJ is shying away from negative interest rate policy and plans to increase the issuance of 40-year JGBs has shifted the JGB curve to the upside. The absence of any pick-up of inflation expectations in combination with higher nominal yields have pushed real rates up adding to JPY strength.
We think the significance and impact of real yields within FX markets differs. Where yield curves offer central banks an adequate transition mechanism to translate new easing measures into lower real yields, this should be generally good for monetary conditions. For these central banks, if either productivity or real GDP are not rising then this could mark a turn for these central bankers to become more accommodative. This could be the case for the US should its recent real yield increase lead to more equity market weakness, spread widening and investment weakness. Given the position of the US yield curve the Fed can steer real yields wherever it wants real yields to settle down. This explains why real rates and yields have less of a supportive impact on the USD. There where central banks no longer find adequate transition mechanisms such as in Japan and now increasingly in Switzerland, Euroland and Sweden, rises in real rates may have a more lasting upside currency impact as central banks find it difficult to push down the rates.
There is good reason for the UK MPC to act given the pace at which especially the supply side of the UK economy has deteriorated since Brexit. The government and BoE’s target should be to improve supply side conditions where an undervalued GBP could help. Lower rates and QE would weaken GBP. Should the MPC opt for a funding for lending program, i.e. leaning onto the qualitative side of its easing instruments, supporting banks hurt by any rate cut, the currently short positioned GBP market would rally. We think there is an assymetric risk for the currency over today’s meeting due to the wide expectations for aggressive easing today and extreme short positioning in GBP. A 25bp cut without providing strong forward guidance suggesting the BoE could expand asset purchases/cut rates further if needed would cause GBP to rally. We look to sell GBPUSD at 1.3420/1.3500. What is important for the longer term is the size of the UK’s current account deficit, which would suggest policy should focus on supply instead of demand. As long as GBP weakness does not generate spread and asset volatility the MPC should not have any reservations about putting conditions into place to weaken GBP from here. The chart below shows that the UK 7%/GDP current account deficit is predominately caused by European counterparts adding support to our view for EURGBP breaking higher targeting 0.92-0.94.