USD Strength, USD Real Yields, USDJPY and hedging flows, AUDUSD weakness
USDJPY is our biggest buy, with our target of 130 looking less ambitious by the day. EURUSD should break the March-15 1.0463low,heading towards parity. AUDUSD is one of our favoured shorts. With the equity market looking increasingly overstretched as real yields go up, USDKRW is set to break higher.
The Fed has been more hawkish than we thought moving its dot plot higher. Interestingly, markets moved more during the course of Janet Yellen’s press conference compared to the release of the interest rate statement as it took the notion that a dovish central bank President may no longer guarantee a dovish Fed. The yield curve went into an early bearish flattening moving our playbook forward. Abearish flattening of the US yield curve would set the starting signal for US real yields to rise which finally would create increasingly strong headwinds for risky assets. Remember, it is the real yield level driving equity valuations, and with real yields moving higher ‘multiples’ will have to come down. This does not suggest equity markets coming under immediate selling pressure, but risky assets will from now onwards require a stronger earnings support to maintain current price levels
Higher US real yields have provided the USD another shot into the arm with USDJPY breaking once again important resistance levels, suggesting this currency pair will accelerate its pace of appreciation once again. Only a few weeks ago our USDJPY target of 130 looked super ambitious. Now it looks moderate – for the authors, a taste too moderate. There are a few observations underlining USDJPY bullishness. The chart below compares the latest (upgraded) dot pot with the current market pricing for rates. While the spread between market pricing and the median assumptions of Fed participants has narrowed over recent months, the market is still under pricing the Fed which, at a time when the output gap is closing and the US economy is moving towards a fiscally supported growth model, is a substantial risk for markets to bear. This observation receives additional support from Janet Yellen down playing a previous comment suggesting in yesterday’s press conference that she has no appetite to overheat the economy.
While the option market’s skew suggests bond markets heavily betting on bond yields to rise, the 17% rise of USDJPY has come as a surprise for many, expressed by light positioning. This morning’s release of the MoF’s weekly security flow data revealed foreign investors piling into JPY denominated bonds (Y731.0 bln) and money market instruments (Y981.8 bln). Parts of this flow could be related to USD deposit holding banks arbitraging away some of the wide cross currency basis. The evolution of the USDJPY basis swap will provide the answer. If the spread remains wide then the increased foreign participation within Japan’s bond and money market may just be another expression for the market to believe the current USDJPY rally. The Tankan report suggesting that the average USDJPY estimate of exporters for 2H16 is at 103.36 tells us next year they may become increasingly overhedged. The reduction of hedge ratios would support USDJPY.
Rising US real yields will have significant implications for currencies of areas with wholesale-funded banking communities. Australia belongs in this camp and hence we are dismissing today’s strong read of its November unemployment report. Yesterday, AUDUSD failed to overcome its 200-day MAV so is looking vulnerable from a technical perspective. Importantly, higher US yields will increase funding costs globally with areas with wholesalefunded banks importing this new tightness quickly.Local funding costs will increase accordingly, which in the case of Australia’s overvalued real estate market could unleash deflationary forces. We recommend AUD shorts.