gfx-1

 

Global Markets, USD, AUD and JPY

 

The USD has given up some of its recent gains with high yielding EM and commodity currencies staying in demand. The Fed leaving the door for a December rate hike wide open has the potential to push December rate expectations by up to 60%, but should the Fed revise its economic projections lower and reduce its terminal rate projection then the USD should receive little support from here. Instead, risk should rally pushing funds into higher yielding assets.

The interpretation of the BoJ is more difficult. Should the BoJ cut rates and re-direct its QE operation into the front end of the yield curve without using other measures to boost inflation expectations then the JPY will rally. Nonetheless, the market is positioned this way as IMM long JPY positions show. Should the BoJ or the MoF find a way to boost inflation expectations allowing the JGB yield curve to steepen without increasing real anticipated yields then markets will be caught by surprise. In this case, the JPY will come under lasting selling pressure. A steeper curve underpinned with higher inflation expectations has the potential to create positive feedback loops with the banking sector working as the catalyst. In this case the steeper curve will provide banks with conditions to ‘recapitalise via the yield curve’, similar to the US banking sector during the 1980s. Higher bank profitability may allow banks to move away from the low return/low risk environment and allocate assets into higher yielding environments. The low banking sector profitability and deflation risks are interrelated. Creating conditions for better banking sector profitability via an inflation-expectations-supported yield curve steepening may turn Japan for the better.

This year the JPY has been the best performing G10 currency,gaining 19%. Ithas been the first time since 2011 that the JPY has rallied by three quarters in a row. At the start of the year the consensus suggested Japan’s debt monetisation leading to JPY weakness. The pace of debt monetisation has even increased with the BoJ increasing its total security purchases to JPY80trn a year, but against conventional wisdom the JPY has rallied. We cite the decline of Japan’s monetary velocity as the reason why the relative increase of Japan’s monetary base has not weakened the JPY. Ithas been the financial sector’s balance sheet weakness increasingly blocking distribution channels via which the BoJ’s increasing monetary base would have increased ‘effective’ JPY supply and credit availability. Ithas been the decline of Japan’s monetary velocity keeping JPY real rates relatively elevated pushing the JPY higher. It is now the BoJ’s task to unblock the financial sector distribution channels, increasing monetary velocity and decreasing real yield differentials allowing the JPY to weaken.

BoC Gov. Poloz speaks today on the topic of “Living with lower for longer” where we expect him to reiterate the need for fiscal policy given the declining impact of monetary policy. Nonetheless, we may get Poloz reinforcing the dovish tilt of the September statement which noted that the risks to the inflation outlook have “tilted somewhat to the downside.” This is an important change given the BoC’s habit of maintaining a neutral risks outlook (even before cutting rates the following meeting) and, to us, signals their willingness to ease if economic activity doesn’t bounce back in line with their optimistic forecasts. With only 5bps of cuts priced by next year, we are watching this week’s retail sales and CPI figures as catalysts to cause further easing to be priced into the curve. We like shorting CAD against other commodity currencies and are currently short CAD/NOK in our portfolio. The Norges Bank is in a tough spot this week, seeing stable data but growth that is slower than a few years ago. The risk to this trade is if the Norges Bank cuts rates this week.

The RBA’s minutes suggested that its current monetary stance was consistent with sustainable growth and achieving its inflation target over time as the decline in China’s growth was offset by some positive local news. Australia’s Q2core Logic’s home value index showed a 3.8%Q.