Weekly FX – Yen carry trade in vogue again

by: Georgette Boele

A big theme in currency markets recently has been the weakness of the Japanese yen across the board and strength of GBP, EUR and USD versus the other currencies. The yen has been undermined by expectations of more monetary easing by the Bank of Japan and the re-instating of carry trades. This week we expect the US dollar to receive support from stronger US data and dovish ECB comments to hurt the euro.

Yen sell-off restarted…

The sell-off of the Japanese yen (JPY) has restarted since the Bank of Japan’s monetary policy decision on 21 November. Since then comments from officials have accelerated the move. The Japanese yen has fallen out of favour again across the board, because the Bank of Japan is expected to ease monetary policy further so that it is able to reach its ambitious inflation target. The market perception is that the bold monetary policy easing will unlikely be matched by any other central bank. This is why yen weakness has been so widespread. Moreover, investor sentiment has remained positive reflected by low volatilities in equity and currency markets. This has stimulated investors to set up carry trades with the yen as funding currency. In addition, bond forecasters who anticipated a rise in Japan’s benchmark government bond yield to above 1% have capitulated, resulting a move lower from 0.65 to 0.60%. Last but not least, the government pension investment fund may reduce its domestic bond holdings. It is pressured to make higher returns in order to be able to cover pay-outs. This will likely result in more substantial investments overseas. We need to keep in mind that, fixed income flows are likely be partly hedged though.

 

131202-Weekly Eng_FX_Spot perf vs JPY1

… but some risk of near term reversal

The factors driving the yen lower have been part of our central scenario this year and also explain our forecast for further yen weakness in 2014 and 2015 versus the US dollar. However, we need to highlight that that some markets signal some risk of a near term reversal. For example the options market showed a substantial change in bias from being USD/JPY positive to modestly negative, while USD/JPY steamed ahead. Such divergence is merely a warning sign and often the spot and the options market align again shortly after such a development. We expect the options market to start signaling more demand for the upside in USD/JPY again soon. Another driver to watch is the behaviour of the 10-Y government bond yield spread between the US and Japan. Usually this is usually a very strong driver for the direction in USD/JPY. Recently, however, the move higher in USD/JPY was not supported by a widening yield spread in favour of the US (see graph below). We expect this to be temporary and better-than-expected US data this week to result in an alignment again.

 

131202-Weekly Eng_FX_USD index

Sterling outperformed last week…

At the start of the weak sterling was under modest pressure driven by lower home loans and by comments from Bank of England (BoE) Governor Mark Carney that the MPC will focus on the economy when the 7% unemployment threshold is hit. Later in the week, sterling outperformed other major currencies. The main reason behind is that UK interest rate expectations have moved higher. Moreover, on Thursday BoE Governor Mark Carney unveiled changes to the central bank’s Funding for lending Scheme that will mean it only applies to business loans from 2014 and no longer be available for household borrowing. He said that these changes will help keep the housing market on a sustainable path and help to ensure that the broader economy continues to receive the stimulus it needs. Sterling moved higher on the result as this signals that the BoE is concerned about the strength of the housing market.

 

1231202-Weekly Eng_FX_EUR_GBP

…but the USD likely to outperform this week

The USD showed another mixed performance last week, outperforming the Norwegian krone, New Zealand dollar, Canadian dollar, Australian dollar and the Japanese yen, while underperforming the sterling, the euro, Swedish krona and Swiss franc. The mixed US economic did not help the USD. This week is a crucial one in terms of US economic data with ISM, Fed Beige Book, GDP and Employment report, all scheduled to be released. In general we are more optimistic than market consensus. As a result, we expect the USD to strengthen this week.

The euro to be undermined by dovish ECB commentary

Last week, the euro was pushed up by higher than expected inflation data, which reduced chances of near-term aggressive monetary stimulus. Nevertheless, we expect dovish ECB commentary and subdued inflation forecasts at the Governing Council meeting to undermine the EUR.

EM FX doing well versus JPY

Most emerging market currencies underperformed both the USD and the EUR but outperformed the Japanese yen. Exceptions to the rule were the Brazilian real (BRL), Indonesia rupiah (IDR), Chilean peso (CLP) and South African rand (ZAR), which also weakened against the yen. Last week the Copom in Brazil hiked interest rates by 50bp to 10% as widely expected, but made changes to the statement, which made it less hawkish. This signals that rate hikes will continue but at a slower pace. This has hurt the BRL. The market has been quite nervous about a court ruling that could hit banks. The Supreme Court postponed the ruling to 2014 on depositors seeking reimbursement for losses stemming from government policies adopted to fight hyperinflation in the 1980s and 1990s, which may cost banks USD 65bn. In the case of the IDR, the market is nervous about the possible impact of a tapering of US monetary stimulus as it is dependent on foreign investment flows. Sentiment has therefore remained weak. The authorities appear to be ready to intervene in currency markets to stop the slide in the IDR.

 

131202-Weekly Eng_FX_Spot return vs JPY2