The FED, USD Yield Curve and the JPY

Central banks will be in focus this week, with the BoJ meeting today and tomorrow the starting point. While Governor Kuroda and company are not expected to reveal any changes to the JPY80trn/year QE programme, market participants will watch if there will be any projection change of the BoJ’s 2%Y inflation target into 2018, which may delay further monetary easing steps. Hence, JPY may rebound in the short term, but any setback in USD/JPY into the 103 handle is viewed as providing a JPY selling opportunity.

There are a number of reasons for our JPY pessimism. First, the market is still long JPY as illustrated by Friday’s IMM release. Speculative accounts had net yen long positions of +44,595 contracts as of October 25,vs. the previous week’s net long of +36,991 contracts and the record high of +71,870 contracts seen on April 19. Second, the US yield curve has steepened in October and the steeper US curve is not yet fully priced into USDJPY. Should our economists’ projection of an October US payroll gain of 205k prove correct, thus exceeding the 175k consensus expectation by a wide margin, then USDJPY should receive another boost, inspired by an even steeper US yield curve. Third, Japan’s fiscal authorities should turn increasingly into focus not due to a renewed fiscal package, but due to the structure of its debt book into the back end of the JGB curve. Japan’s back-end yields staying under upward pressure not only allows the BoJ to execute its JPY80trn QE programme conveniently, but it can also reduce back-end JGB yield volatility, which may be the precondition for banks to shift their JGB positions (which constitute 17% of total bank assets) from the front end towards the back end of the JGB yield curve. Fourth, Japan’s authorities may have to focus on increasing monetary velocity to fight deflation successfully. A precondition for a higher pace of monetary velocity is commercial bank profitability picking up. Here a transparent, stable and positively sloped yield curve is required.

The US FOMC will meet Tuesday and Wednesday. There will be no press conference, but the statement should provide what we call ‘guidance towards Fed tightening’ in line with our economists’ call for a 25bp rate hike in December. Last year, the Fed used its October statement to provide the green light towards a December hike by saying: “In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress – both realized and expected – toward its objectives of maximum employment and 2% inflation.”

Remarkable is how flat rate expectations for 2017 have remained, illustrating a significant difference to last year when the market was convinced the Fed would hike rates by 65bp over the course of this year. The steep fall in EM markets in autumn 2015 and January 2016 and risk appetite getting hit in January expressed by a 10% decline of the SPX accompanied by widening credit spreads led to a subsequent correction of rate expectations. This time, markets look very different. There is only 20bp priced in for 2017, EM markets have remained resilient and the SPX trades only marginally below historical highs.