FX trader - All upside for the USD as the JPY is carted out

7 sept. 2022

It’s days like this that running a trend and/or momentum strategy works wonders. The USD pairs, notably USDJPY, USDCNH and USDCHF are ripping – We see the JPY as the weakest though with USDJPY spiking to 143.59 in early trade today, on what looks like a stop run through yesterday's session highs and amid thin liquidity.

The trade-weighted JPY sits at the lowest level since 2007 and some are questioning if the risks of verbal JPY jawboning from the Bank of Japan or the Ministry of Finance (MoF) have increased?

Potentially, but in this current bond driven dynamic the market will pounce on JPY weakness. Consider that we haven’t seen a sizeable lift in Japan’s inflation expectations as a consequence of Japan importing inflation (through the FX channels) and that will appease the BoJ. Commodity prices have come well off the highs, which will benefit energy importers (like Japan).
However, we are back to trading central bank divergence – FX trading in its purest form, albeit from a fundamental perspective. Don’t fight the Fed means staying long the USD, at least for now.

We can see the central bank divergence manifest in the FX forwards markets, where corporate treasurers are able to roll over USDJPY exposures for 12 months at a 600-pip discount – interest rate parity dictates this, but when you get this level of carry you know the JPY has very little safe-haven qualities, and in this current environment the JPY is simply a bond proxy. For the JPY to really head higher bond yields need to trend lower – the JPY (and perhaps gold) would become the default hedge if bond yields really started to head lower on global recession fears – not a trade for right now, but it could play out in late 2022 – recognise the signs and have the theme on the radar.

The fact we continue to watch US bond yields climb is pushing more capital into the USD – some of the recent moves can be explained by US corporates issuing a high level of corporate debt and the market having to sell out of other fixed income instruments to fund this. Some have been driven by slightly better US data (ISM services for example).

US ‘real’ rates (US Treasuries adjusted for expected inflation) are moving higher and higher. It also feels like the USD market is front-running Fed Quantitative Tightening (QT), which ramps up to the incredible pace of 95B this month - we have seen a strong relationship between falling Fed reserve liabilities and the USD and if this relationship is maintained then USDJPY could be headed for Y150+ over time.

Draining reserves (system liquidity) aside, the real effect from QT would come if the US Treasury were to beef up issuing longer-duration Treasuries in late 2022/early 2023 – when you remove a price-insensitive buyer (the Fed) from the market the private sector is asked to step up the heavy lifting, and that can mean compensation in the form of higher bond yields.
Is the FX market front-running this QT process…? Feels like that is the case.

The BoJ on the other hand remain steadfast in its dovish stance and the market may start to think about taking them on again. We shall see, but the easier trade has just been to short the JPY, than the Japanese bond market.

Next Tuesday we get US August CPI, and this could be huge for the markets and especially the USD. The market will go into a frenzy of excitement about the implications of the CPI print, but in a world where we’re so desperate to hear of peak inflation if we get an upside surprise, it could be painful for USD shorts. Of course, with the world so long of USDs, a downside surprise vs consensus, especially if it came from both headline and core inflation. The playbook is set, but needless to say, this is the event risk to have on the radar.

Nearer-term we listen to speeches from Fed VC Brainard (02:35 AEST) and Chair Powell (Thursday 23:10 AEST) and their views will move the USD, so keep this on the risk radar.