Global FX: USD bouncing higher, USDJPY, Yellen and closing output gap, CAD losing ground.

Yesterday USDJPY developed, with the help of Janet Yellen,a key reversal day testing a new low (1.1257) during the Asian session and closing the New York session (1.1465) above the previous day’s high (1.1428).Further gains are in store as Yellen’s remark suggests the Fed standing reading to hike rates at a faster pace than currently priced into the rate forward curve. It is the differentiation between an output-gap closed economy (The Fed’s Beige book data was positive yesterday) receiving a fiscal stimulus compared a situation of an output-gap running economy receiving a stimulus. In the latter case the size and the implementation pace of the package is of greater importance compared to the first case.

An output closing economy should see capex improving. Capital expenditure suggests higher capital demand which, within an environment of constant domestic savings, must lead either towards a higher USD driven by capital inflows or higher bond yields. Receiving a fiscal stimulus when there is an output gap suggests the fiscal stimulus may contribute to closing the output gap, but there is no guarantee that the stimulus leads to higher capex. For instance, in the case where the stimulus is inadequate size-wise or its implementation turns out to be too slow; then markets will see a bigger disappointment with the USD and bond yields falling back sharply.

Making this differentiation between an output gap closing economy and an economy offering output gaps is essential for trading within our current framework. Yesterday’s hawkish comments from Yellen and Kaplan address the fact that the US has closed its output gap suggesting rates should be moved towards turning policy neutral. This level is currently estimated at 3% suggesting that the current US monetary policy set-up is highly accommodative. Seeing real Fed funds rate falling below -1.0% as inflation has rebounded at a quicker pace than the Fed hiking rates adds weight to this view. Seeing the US equity market rallying in reaction to hawkish Fed commentary underlines the pro cyclical market set-up. The difference from last year could not be more pronounced. Fed Q4 2015hawkishness flattened yield curves, pushed inflation expectations off the cliff, undermined EM currencies and finally led to a sharp equity market decline. Yesterday saw US long end break evens rising (December CPI did beat market expectations), the yield curves staying steep and the equity market turning early losses into moderate closing gains with financials leading the pack.

The BoC leaving the door towards a further rate cut wide open fits well with our output-gap differential driven framework. Policy divergence coming on the back of inflation divergence should weaken most currencies against the USD. The CAD will be not an exception as a cut in the policy interest rate, currently at 0.50%, “remains on the table” should major downside risks to the economy emerge. Those downside risks could largely stem from the trade-related policies of the incoming U.S.administration. Designated Commerce Secretary Ross said the Trump administration will turn quickly to deal with trade relations with Mexico and Canada in the context of NAFTA.