USD Index, JPY and BOJ, AUD and NZD weaker and driven by bonds

The USD index (DXY)has gained over 4% from its recent September low with USDJPY reaching its highest level for three months. This move has been supported by rising bond yields and the related steepening of G4 yield curves. Given the extent of the recent bond yield increase and the subsequent USD rally, the resilience of risky assets is remarkable suggesting the USD gaining further momentum against low yielding currencies. A lower JPY remains our expectation. This trade has received further support by the release of Japan’s CPI showing October Tokyo inflation reaching positive ground. Today’s market focus will be on the first release of 3Q US GDP.

The combination of higher inflation data and the steepening curve suggests Japan moving slowly away from an environment where the BoJ has no influence on real rates. It was this inflexibility which we described as yield curve exhaustion being the key catalyst for JPY strength experienced from November until September. Now as curves steepen and inflation rises the JPY outlook weakens by the day. Japan’s jobless rate trading at a 21 months low and household spending reducing the pace of its weakening trend are further adds to our bearish JPY call. The performance of bank shares may preclude changes of money velocity. Should Japan’s money multiplier rebound it will convert central bank liquidity into high powered liquidity increasing effective JPY supply. Today’s data showing higher inflation, labour market tightness and a steeper curve should push bank shares up putting Japan closer to a situation where its money multiplier can accelerate.

Between February and March of this year, Japanese investors and corporates started shifting their view on the JPY. Instead of continually expecting BoJ policies to work to weaken the JPY, their habits started to shift towards a neutral JPY stance, which we think added to JPY upside pressure. Today the tide appears to be turning in the other direction, with initial signs that further JPY appreciation may not be expected, perhaps because USDJPY has failed to break back below the psychological level of 100. The USDJPY rally will accelerate as this transition occurs. Driven by the weakness in JGB’s, current valuations are making local investment less attractive. This week four major Japanese insurers said they either plan to cut yen bonds or boost foreign notes. If the cross currency basis makes it expensive to FX hedge or the investor no longer expects further JPY appreciation then they may start to invest in foreign bonds without the FX hedge, which would weaken the JPY. Last week Japanese investors bought JPY773bn of foreign bonds, taking the 12m sum to JPY25.3trn. So outflows have been going on all year and should continue, but the FX hedging activity may change. The Japanese retail FX community have very light positions on at the moment but their activity could soon shift towards taking advantage of the carry trade once again.

The commodity driven currencies are generally the most sensitive in G10 to market volatility, however this week the FX weakness we would have expected has been cushioned by rising commodity prices. We are still short AUDUSD and NZDUSD in our FX Pulse portfolio, partly on expectations of a stronger USD rally. Chinese iron ore prices have rallied 7% this week. It is not clear whether the rally has been supply or demand driven. On the supply side, a few large iron ore companies reduced their production forecasts recently. On the demand side, our China commodity analyst has been suggesting that there is some restocking in place at steel mills. We don’t think the rally is driven by the increasing use of margin trading seen at the start of the year, as the number of days a future contract is held for is currently 6 days, relative to between 2-3in March. For NZD, we think the milk price rise has been driven by reduced supply, with Fonterra reducing their forecast for milk production in the coming year by 4.1%. Higher bond volatility is a negative for both these currencies.