USD, Money Supply and Yellen, BOJ yield curve control
USD should remain bid across G10 and EM currencies, with Fed Chair Yellen’s testimony (released 1pm Ldn) and the US October CPI release in focus today. Our favourite way to play for USD strength has been to pick G10 currencies most sensitive to curve steepness (JPY and CHF) and EM currencies where local companies have high debt levels and may rely on foreign funding (KRW and TRY). The pace of USD’s strength has been faster than our base case suggested so far for EURUSD, which we think is largely driven by the USD side of the pair, so we move towards promoting our bear case of 0.92 by end-June 2017. We still see EUR outperforming on the crosses, with buying EURJPY still a top trade. AUDUSD should continue to underperform, with the labour market data for October showing downward revisions and still a larger number of part-time jobs being created over full-time ones.
The BoJ is taking yield curve control seriously by announcing today unlimited bond buying at a fixed rate to stem the yield surge. This outcome is diametrically opposed to market expectations seen less than two months ago when the BoJ announced its new yield curve control idea. Then the market assumed a too flat curve, forcing the BoJ to reduce its JPY 80 trillion yearly easing programme. This idea was based on the BoJ either controlling yield or the quantity of its easing programme. While this assessment is correct in principle, the fact that global yield curves have steepened now allows the BoJ to execute optimal control. Now it can even increase the size of its balance sheet by trying to keep the curve near the desired slope while keeping JGB volatility low. While the BoJ was unable to buy bonds at the yield they offered, it was a big sign that it is being serious about yield curve control and that these levels (-0.09% for 2y and -0.04% at 5y) may suggest a cap on the yield level it is willing to tolerate.
JPY should weaken further from here as Japan’s yield curve management must lead to widening yield differentials within a globally reflating word. USDJPY and EURJPY look attractive as short JPY market positioning is nowhere near where macro analysis would suggest. Today the market will also be watching for any developing stories on the Japanese growth front as PM Abe will meet with US President elect Trump. We stay long USDKRW, which has continued to march higher as political uncertainties grew, but we think there are also other reasons to expect this trend to continue. KRW loses attractiveness within a higher-yielding global environment. Its high leverage particularly within the corporate sector will likely unleash balance sheet consolidation pressure once funding costs increase beyond the return of investment (ROI). The ROI should stay low as Korea’s capacity utilisation continues to decline. US yields watched for USD: The rise of the US 10y yield has taken a breather over the past few days, settling around 2.20%. The market probability of a December Fed rate hike is now at 94%. Today the market will be looking for Yellen to provide guidance on how the Fed could change forecasts in response to changes in fiscal policy, but we think it may need to wait a bit longer for this type of guidance. Instead, the focus may turn to the pace of rate hikes she expects next year and what would make her tighten more than the market is currently pricing. Monetary conditions remain loose, with latest data from CFS Divisia suggesting that broad money supply growth accelerated in the US in October to 5.81%Y from 5.45%Y,adding to inflationary pressures. Last week saw another US$9bn decline in custody holdings of Treasuries by reserve managers at the Federal Reserve . This selling pressure will largely be a reflection of reserve managers defending weakening currencies. As USD continues to rise, this selling pressure will likely continue, putting upwards pressure on yields and in return USD.