USD Strength, US Bond Market and the JPY

USD strength is making the headlines, with the DXY Index trying to make its way through the key 100 level, but we are noticing that the weakness in JPY is being debated less. We think the rising USDJPY is the real pain trade in respect of positioning. That said, the moves in the JGB market are being closely watched by our team. On JPY positioning, when the USDJPY rally started in September the JPY long position was extreme relative to its long-term average. Now, as the pair trades impulsively higher, supported by rapidly gaining real yield differentials, investors are not as long as they would like to be, given the change in the global macro picture. Hence, we think it may be wrong to speculate that the DXY is forming a ‘triple’ top coming off from here. Markets will be looking for a break of the 100.51 high in the DXY from December 2015. We see no reason for USD to correct and USDJPY to trade lower.

As US bond market volatility eased yesterday, USDJPY in particular was able to move higher based on an upside surprise in US economic data. In fact October saw the best rise in core retail sales since April, with support from a slightly better Empire State Manufacturing PMI for November (+1.5 after -6.8), driven by the new orders and shipments. The President-elect’s fiscal and deregulation proposals have fallen on very fertile ground, namely a US economy showing signs of closing it eight-year output gap. Core PCE has been resilient, not reacting to falling import prices to the extent it did for most of the post-Lehman time. In fact, our economists noted that the US import price index has shown some reduction of the pass-through of prior dollar strength and China PPI deflation that fed into core goods inflation.For markets the inflation data are important as the sharp rise in US nominal yields is this time not being primarily driven by rising real rates as seen during the 2013taper tantrum, but by upward-adjusting long-term inflation expectations.

JPY remains vulnerable at this stage as global reflation signals become stronger by the day. Even in Japan 3Q growth has been stronger than expected, providing a positive signal of Japan’s own inflation expectations. Lower Japanese real yields are undermining JPY. As the Japanese 10-year yield crossed above 0% yesterday there was some expectation building about whether the BoJ may purchase more bonds to bring the yield lower towards target. The BoJ didn’t adjust purchase volumes today, which may have added to the selling pressure in the short end of the JGB curve. Higher nominal Japanese yields are weakening JPY as long as US yields are rising faster. This morning Hamada, an advisor to Japan’s PM Abe, has been suggesting that fiscal spending (which we suggest is inflationary) may be required and that money supply shortages may help to explain deflation. Other low-yielding currencies such as CHF and KRW – where we propose short positions – have weakened too. USDKRW has breached the 200DMA and USDCHF has breached parity. More weakness will be in store as yield differentials move rapidly in favour of USD, in our view.

So far JPY cross traders have focused on AUDJPY, arguing that reflation combined with rising commodity prices are supportive for this cross. However, AUDJPY momentum may slow once investors realise that AUD’s vulnerability is linked to rising global funding costs. While Australian banks have reduced their wholesale funding dependency over recent years, the banking sector may experience higher funding costs from here, suggesting local credit costs going up despite the RBA leaving rates low. This implicit tightening of financial conditions may make it difficult for its overvalued real estate market to hold up. Overnight, Australia’s wage index for 3Q was slightly weaker than expected at 0.4%Q (0.5%Q e) and iron ore prices are down again after commodity exchanges have put in measures to curb market speculation.