Article / 28 December 2016 at 23:39 GMT

Rate differential stagnation keeps USDJPY and EURUSD on hold

Managing Director / Technical Research Limited
New Zealand

  • Japan still in deflation but the Bank of Japan remains steadfast
  • USD index being driven by US versus Germany yield spread
  • Trump-effect on US rates is wearing off and inflation rising in Europe

 By Max McKegg

The US dollar index is going to end the year at its highest level since 2002, supported by weakness in the two currencies with the largest index weighting: EUR and JPY.

Interest rate differentials, especially at the 10-year maturity, have been the driving force, with US rates doing the heavy lifting.

But it’s difficult to see that continuing in the short term as the Trump effect reaches maturity and inflation picks up in the Eurozone and Japan.

While trading in European markets has been quiet over the Christmas holidays, it’s been business as usual in Japan, with an inflation update and a speech by Bank of Japan governor, Haruhiko Kuroda.

Japan is still in deflation according to the bank’s benchmark, the consumer price index (less fresh food).

Over the twelve months to the end of November, the index declined by 0.4%, having made no improvement on the previous month.

Japan’s problem with inflation, or rather the lack of it, is illustrated by this chart: the CPI is barely above where is was twenty years ago.
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 Source: Bloomberg
 
You gotta have faith

As usual, Governor Kuroda put the best possible spin on the situation in his speech this week. He said the 2008-2009 global financial crisis had impacted Japan’s economy more than most because of stagnant global trade and a sharp rise in JPY.

However, economic momentum in both emerging and advanced economies was picking up and the excessive appreciation of the yen had been “fairly corrected”.

After years of struggling against the headwind of the global economy, Japan was now able to move forward supported by a tailwind, he said.

Kuroda also re-emphasised his commitment to achieving the 2% inflation target and poured cold water on any idea that Japan is a special case because of its lower potential growth rate (largely due to adverse demographic trends).

He said the neutral – or natural – interest rate is the sum of the potential growth rate and the medium-long term inflation rate.

To ensure Japan gives itself a buffer in the event of another economic downturn “a low potential growth rate should be the reason for aiming at a higher inflation rate” and therefore a higher neutral rate.

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Japan needs yield curve control, targeting short and medium term rates. Photo: iStock

Rather than lowering the 2% inflation target, if anything, it should be raised or at least deliberately over-shot.

Hence the Bank of Japan “inflation overshooting commitment”, announced in September.

This will require an extended period of low real rates, and to ensure global influences won’t interfere, yield curve control – targeting both short and medium term interest rates – was introduced at the same time.

This will also avoid any crowding-out effect caused by bond issuance to finance an increase in government fiscal expenditures.

The impact of this strategy has shown up in an expansion of the US versus Japan 10-year yield spread, as shown in this chart. FX traders will notice USDJPY has gone along for the ride.

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Source: Financial Times

The dominance of the 10-year yield spread in determining FX cross rates is also apparent in the Eurozone.

The top and bottom panels in the chart below display an obvious correlation. The EUR makes up more than 50% of the USD index.

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Source: Bloomberg

For the USD to strengthen further against EUR and JPY the 10-year yield differential will have to lead the way.

But with a record number of short speculative positions in US Treasuries it will take more than simply relying on the Trump-effect to push yields up towards 3%.

Rather, next week’s jobs report will have to beat expectations by a decent margin.

Meanwhile, in the first half of 2017 base effects – previous oil price impacts dropping out of the annual calculation – will see inflation rising above 1% in the Eurozone, and firmly into positive territory in Japan.

This will lead to talk of Quantitative Easing tapering by the European Central Bank and a loosening of yield curve control by the Bank of Japan.

All told, it’s hard to see rate differentials expanding much in the short term, meaning EURUSD and USDJPY look set to stagnate for a while.


-- Edited by Adam Courtenay

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade, then click here to follow him.


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