US Elections and the USD, BOJ, ECB
Reflation is back in the game as investors look at the positive aspects of yesterday’s surprising election outcome. We believe that this environment of rising US yields (10y crossing 2%), inflation expectations (5y5y at 2.43%) and a risk event out of the way have cleared room for the USD rally to start in earnest. The reflation story goes beyond renewed expectations about fiscal spending in the US as metals prices were already rising prior to the election. The CRB RIND Index, a measure of commodity prices based on demand rather than speculation, has rallied 6% since its October low. For now, as long as financial conditions don’t tighten (i.e., market volatility stays contained) then a December Fed hike should remain in play. Buying USDJPY or EURJPY are our best FX expressions of this theme. For our FX portfolio we are paying less attention to the constant fluctuations in oil, where yesterday EIA inventories rose again.
The US breaking away from a model of previously using monetary easing (the Fed) to do most of the heavy lifting to support the economy suggests steeper yield curves laying the foundation for an increase in money circulation in the US. Prospects of lifting some of the post-Lehman financial regulation should free up some bank balance sheet capacity, allowing a better transformation of central bank liquidity into high-powered liquidity, increasing the money multiplier. As we described in this previous note, the higher credit creation would lead to stronger bank equity prices (from prospects of higher profitability) and could lead to higher inflation, supporting USD. Fiscal policies are now en vogue. This happens at a time when US data were already improving and global deflationary pressures receding.
This morning the BoJ reiterated that its yield curve control is working smoothly. We agree with the view and see rising global inflation expectations pushing yields higher, helping the BoJ to continue its JPY80trn QE programme while keeping the JGB curve within a desired, slightly upwardly sloped fashion. The 10y JGB yield has remained fairly anchored. As global yields rise relative to Japan, foreign investment becomes more attractive, which if JPY is weakening is more likely to occur on an FX-unhedged basis, causing any outflows to be a negative for the currency. Last week Japanese investors put money abroad for the fourth week in a row, buying JPY604bn of foreign bonds and JPY183bn of foreign equities. The US, UK and Sweden’s 10y bond yields currently offer a great advantage over the JGB, even if the most conservative investor overlays with an FX hedge. We also focus on real yields, where the chart below suggests USDJPY should be trading closer to 108 when looking at 10y real yields in the US relative to Japan. Given the positive risk response yesterday, USDJPY does not deserve this high risk premium, we believe. Hence, we reiterate our bullish USDJPY call with force.
Of course, Trump will now be carefully observed to see which of the suggested policy proposals he may prioritise and who is put into top government roles. As long as anti-globalisation rhetoric remains subdued investors will cheer Trump introducing Neo-Keynesianism,hoping to break the gridlock between too low yields and too flat curves undermining the money multiplier within the US. A related theme of banking sector profitability has become a key concern for central banks around the world, including the ECB. Today many ECB members will speak, including Constancio, Weidmann and Mersch. Rising global inflation prospects, with the eurozone’s 5y5y inflation swap now at 1.46% relative to 1.26% in September, may bring market attention back to the ECB tapering debate, supporting the view that EUR should remain well supported on the crosses but with downside in EURUSD driven by rising US rates.For now, we believe that the market must move towards a higher probability of EMU breakingup for EURUSD to fall dramatically.