USD Strength, JPY, CHF and EMFX
Over the course of the past few weeks, US front-end rates have moved higher as the market prices in a 65% probability of the Fed hiking rates by December. This repricing has primarily driven low-yielding currencies, while EM markets have remained protected by their nominal and real yield differentials and risk appetite staying supported. JPY has come under selling significant pressure against USD, supported further by foreigners net selling JPY1.89trn of Japanese money market instruments. The outsized move in USDJPY makes sense to us,given that Japan has a large net foreign asset position worth 65% of GDP. This position requires currency management and, with US front-end rates moving higher, currency hedging has become more expensive, reducing the incentive to currency hedge (no longer JPY-supportive). EMU does not have a foreign asset position and hence the impact of rising US front-end rates on EUR is less emphasised. Switzerland, however, does fall into a similar category to Japan, with higher front-end US rates reducing CHF hedging demand.
The consensus is USD-bearish positioned and a strong believer in Japan staying trapped within an environment of its excess savings keeping the JGB yield curve depressed. The flat yield curve keeps bank profitability low, suggesting banks reducing their balance sheet risks as much as possible. Within this scenario, commercial banks fail to transform base money into broad money. In short, the money multiplier fails to develop the desired effect. While base money rises strongly, broad money supply growth has disappointed. This scenario suggests JPY staying permanently under appreciation pressure resulting from the declining money multiplier reducing effective JPY supply, which is typical for an economy with falling monetary velocity.
We disagree with the consensus view and instead we see JPY coming under sustained selling pressure. The beauty of our position is there is a ‘wall for worry’ and, in this respect, we are reminded of last November, when our call for JPY strength met an equally reluctant market. Then it was Japanese accounts running record currency-unhedged foreign asset positions. Now it the international investor community running near record JPY long positions. Liquidation potential driving JPY lower is substantial. There is an ideal environment for JPY to weaken, with international yield curves steepening, spilling over into the JGB curve. Today, the JGB curve looks almost exactly as it did on September 20, which was the day before the BoJ announced its decision to target 10y yields near zero while keeping its policy rate at -0.1%. Effectively, the BoJ has converted into a yield curve manager. This strategy will be successful if accompanied by international upward pressure on yields or Japan’s MoF choosing to increase the supply of long-term JGBs.