The Quick Read
Higher 10y yields remains likely as some US resilience will persist. The adjusted nominal GDP rate for yields is still consistent with low unemployment and an improving output gap.
Incoming bond supply this week will be important to monitor for Treasury indigestion problems. Higher yields remains the mechanism to move to a hard landing scenario and eventually shift the bias on duration.
That helps USD firmness to become more deeply entrenched. That poses problems for risk assets though on a stock/bond ratio basis, bond are not attractive in the interim. Asia FX will remain in the crosshairs.
The ECB can bark but a hike this week will have no bite. 1y1y rate divergence with the US signal that the tide on the euro has turned against it.
The BOJ has introduced risk of policy change but this should be viewed as a new form of FX intervention for now. It is their way of introducing more variability in the YCC band to help defend against woeful rate differentials.
That said, inflation dynamics are changing in Japan. Coupled with a rising need for yen-denominated assets mean that Treasury supply could yield more market indigestion.
150+ in USDJPY is the line they do not want crossed. But pressure will remain towards it unless Fed policy drastically changes or the BOJ steps up to the plate. Neither are likely soon, though it is prudent to assume that the BOJ may be forced to act in the next 6m.
YCC cannot be “let go”, as that is likely too severe for bond markets. There is also no urgency to adjust it either.
It’s Good to Be King
Apologies for the absence but a lot of things have been going on on my end. I was recently at a conference. There was a lot of USD bearishness and very few bulls. In one corner was some decent discussion over the bad going on in the US (the typical slander of running down of pandemic excess savings) and whether R-star was higher (I think it is). In the other corner was, shall we say, rather useless debates about whether the 10-year R-star is lower than short-term R-star (because that is how households and corporations think of policy and economic cycles…). Interestingly, many USD bears do not realize that the reasons they are bearish the currency are reasons to be bullish (economists…).
The main reason is that the Fed will have to cut rates. I do not disagree that easier Fed policy has the effect of weakening the dollar. But as I noted in my last post “A USD Smirk”, this usually occurs when risk premiums ease via sustained policy reflation that lifts other boats.
Getting the dollar call right is an important one given the multi-asset implication. We have already crossed the Rubicon from a cyclical point of view in terms of USD strength. Last post, I noted that cyclical measures like the ISM services/manufacturing signal a US dollar that should be stronger.
Meanwhile, the 200-day moving average - a measure of trend - was breached to the upside, which historically precedes a continuation of the break.
This comes when US super core inflation, while having moderated, remains very high. This leaves the risk that the Fed has to leave open the optionality to hike again further this year. At a minimum, it means that the Fed will have to revise its long-run dot higher next week as the central tendency forecasts have already indicated.
What’s more is that many central banks appear to be near the end of their own tightening cycles. The ECB is potentially one of them this week. Meanwhile, the market is pricing in about a 40% chance of a Fed hike in November. It does not matter for the euro whether the ECB hikes or holds, it’s that STIR markets are essentially pricing in a completed tightening cycle at a time when European growth has had its challenges recently (and China, a notable growth engine for Germany, has appreciably slowed).
1y1y rates are signaling much more than that however…a divergent monetary policy…
…and for the most part, elsewhere too (Canada being the exception).
I can concede that EURUSD’s descent from 1.12 is tactically oversold. But it trades poorly if you are a euro bull. Note that the trough-to-peak rallies from November to the YTD highs have been fairly consistent in terms of the range. But that has now been eclipsed by a much larger peak-to-trough decline in recent weeks that has broken uptrend support (i.e. the 200-day moving average).
This is somewhat familiar territory where last year EURUSD did the same during its depreciatory phase.
It stands to reason then, that a countertrend rally should be sold into.1.0800/30 looks to be the fade point of the downtrend channel (right where the 200-day moving average lies):
Suffice to say, it looks as if the ECB will need to mark down growth (no surprise there). Even if the ECB hikes or places a hawkish hold, that bark has little bite with what looks like an arguably weaker growth impulse in the bloc and in China.
And whether you are more optimistic that the US will avoid a recession or more bearish that it is inevitable means that you are positioned the same way - a firmer USD (and steeper curves if you want to hide your duration view). A more resilient US vs RoW or a deteriorating global landscape/risk-off is bullish the USD. A soft landing just emphasizes it via rate differentials.
And if the US can stay resilient into the balance of the year, that in turn should help force additional repricing in the front-end in favor of H4L and drag 10y yields higher. That last bit is the necessary straw that breaks the camels back for the economy…
…because in aggregate, the current level of yields is historically consistent with a positive trend in the output gap and low unemployment.
So if the path for 10y yields remains higher, then will there be enough foreign interest to absorb it?
Enter Japan
Governor Ueda dropped some important comments that there may be enough information on the inflation front to determine whether monetary policy can change (read: raise the policy rate). Ueda wasn’t alone in making these comments either.
It’s no secret what the BOJ is trying to do. Last year, they weaponized a weak currency to break the deflationary mindset of what was a structural shift for global inflation. Despite rampant price pressures elsewhere, they have intentionally run policy behind the curve to deeply entrench them domestically.
There is already quite a bit of evidence that this is working. On a diffusion index, Japan now looks like what many G7 economies looked like a year ago:
Core-core inflation, the BOJ’s preferred measure, sits at multi-decade highs. The Tankan survey of output prices are flagging some price passthrough as well - again, for the first time in decades.
So, clearly there is some truth to the matter.
At this point however, comments from Ueda should now be viewed as another form of FX intervention and are buying time until they can change policy again. Last September, the MOF intervened to interrupt USDJPY’s ascent above 150. But unilateral ‘yentervention’ is not a sustainable policy (even though the MOF is sitting on ample firepower), and it was the signal that the BOJ would have to adjust YCC.
For USDJPY, Japanese policymakers cannot risk a breakout above 160 (the 1990 high). It would be too damaging from a psychological and technical perspective (there’s a lot of air up there on a break). So it is paramount that Japan officials stop it well ahead of its tracks.
That augurs for fading USDJPY around 150. But carry is a powerful force so unless rate differentials start to change, then the BOJ might have to play ball.
Ueda’s rhetoric adds extra weight to MOF commentary (which has no doubt intensified) over the yen’s weakness. Culturally, Japan does not like a lot of change or volatility. The same applies to policy and investing. Speculators can try, but the BOJ will not make a change when vols have spiked. The element of surprise gives the BOJ some form of control over decades of easy policy. The BOJ will make a move when it is least expected (see YCC change in December 2022) and they will lull you into complacency.
It’s possible that the BOJ is stepping up the rhetoric to sow the seeds of the impossible change that the market has grown accustomed to for so long. It’s also possible that the BOJ is concerned that US yields may have further upward adjustment given supply or a higher R-star/more resilient US economy, which would necessitate some policy flexibility to fight against it. Either way, the market is now doing what the BOJ wants and reflecting risk of policy shift and that may be enough to give them more variation in 10y JGB yields to move towards the upper end of the band. Perhaps enough to fight against USDJPY upside from rate differentials. It probably explains why they intimated a change to the policy rate as the last time they adjusted YCC to 1%, it was not as market shattering. They need more bang for their buck so to speak.
At the same time, they do not want to drive massive yen strength or high enough yields to undo some of the “progress” on inflation. The domestic real money community has altered their expectations of where yields are going. The BOJ dealer survey shows an adjustment in long term yields.
At this stage, the BOJ does not need to change the YCC cap of 1% and it remains highly improbable that they let it go entirely as it could destabilize bond markets. On an FX-hedged yield basis, G7 bonds are extremely punitive. So a 10yr JGB yield at ~70bps is still very attractive in relative terms. That said, Japanese investors have accumulated Treasuries this year. But, unless hedging costs ease, it is not sustainable.
Japan also boasts an aging population. That means there is natural demand for yen-denominated assets. That gives the BOJ an off-ramp for its YCC policy: domestic pension funds and Lifers to replace it as the major buyer of JGBs. That is a slow process and one that will happen over months and years. That means less Treasury buying over a time when supply dynamics will worsen. Yet another concern for long duration seekers.
For now, it is fair to assume that every BOJ meeting is live, not because it is more likely but because you have to. One should reckon that it is easier to adjust BOJ policy when the Fed is done or closer to easing. The reason being is that it means less natural upward drift on yields from global bond markets. Still, there is probably the hope by the BOJ that they do not have to act and that the Fed is done and the economy will cool more meaningfully. But hope can be fleeting.
Good luck.