USD Yields, USD Index Strength, Steepening Yield Curves and the JPY


There is increasing evidence of the USD moving generally back into its long-term bullish trend. Yields have increased across the US curve and spill-over effects have become visible within the G10 and against the low yielding EM currencies of CEEMEA and AXJ. Oil has broken higher as Russia and Saudi Arabia pledged joint efforts to limit oil production providing the final confirmation that the supply boosting strategy by traditional oil producers aiming to price out the shale oil industry has failed. The US, which is the globe’s biggest shale oil producer, will benefit most. This on its own is a USD positive, but the main catalyst will work via higher inflation rates and its impact on yield curves.Low yielding currencies such as the JPY, CHFand probably the SEK may suffer most while the EUR may stay bid on the crosses.

TheFed’s Calendar guidance. When it comes to projecting Fed rate hikes it is important to watch the most dovish members of the committee. Overnight it was Chicago Fed’s ultra-dove Evans suggesting the Fed refraining from rate hikes ‘may be changing soon’. Preventing a before-year-end Fed hike may now require pronounced data weakness to push the market now into a position where the USD is either getting the support from the Fed executing the move and the subsequent widening of USD supportive rate and yield differentials, or through a sharp deterioration of the US economic outlook leading to a setback of risk appetite leading to a repatriation-related USD advance. It seems the Fed has moved into a similar position compared to last year when ithiked rates in December despite seeing growth indications slowing sharply down from December. We may call the current episode ‘calendar guidance towards tightening’. USD strength will be the ultimate result and it will manifest itself mostly against low yieldingFX. High yielding Latam EM should remain supported due to the recently improved election poll numbers for Hilary Clinton.

Steepening yield curves will help the BoJ run its new yield curve management successfully. Japan’s investor audience may look increasingly abroad again investing into long-end bonds on a currency hedged basis Funds pushed abroad instead of investing into long-end JGB’s will provide the JGB curve a lift allowing the BoJ to maintain its JPY 80 trn QE operation without depressing bond yields towards uncomfortably low levels. The steeper international yield curve environment creates conditions for the BoJ to run successful yield curve management.

Analysing the JPY is about understanding the evolution of Japan’s monetary velocity. A steeper and stable JGB curve may allow banks to generate the core profitability putting banks into a position to allocate assets into higher return segments. Consequently, Japan’s capital allocation may become more efficient. This assumption would prove correct should Japan’s M3 growth accelerate from here. The chart below indicates the divergence between M1 and M3 growth. When this divergence started to emerge earlier this year it opened scope for the JPY to rally. Today’s release of Japan’s August current account surplus (JPY2trn)exceeding expectations (JPY1.5trn) by a wide margin is a reflection of Japan declining monetary velocity resulting in the country’s savings exceeding its investments. However, August numbers are like water under a bridge. They provide a historic view, but say little about the future. Should our framework suggesting the BoJ operates a successful yield curve management then M3 money supply growth will pick up, the current account surplus will start to shrink and the JPY will come under good selling pressure.