Fragile risk and growth concerns limiting USD selling

USD: Sintra message stays the same as growth concerns pick up

Currently, the financial markets appear to be disconnected from one another.

FX trading is happening within narrow ranges, while equity markets showed resilience despite falling yields.

The US dollar, however, strengthened against almost all G10 currencies. In Sintra, Portugal, there was a consensus among Fed Chair Powell, President Lagarde, and Governor Bailey that inflation remained dangerously high, suggesting the likelihood of additional tightening measures. On the other hand, Governor Ueda maintained the view that inflation was not sufficiently high to warrant a change in policy.

Governor Bailey expressed concerns about the persistence of underlying inflation in the UK, suggesting that interest rates might need to remain higher for a longer duration. However, the British pound performed poorly against most other G10 currencies due to the news that Thames Water, a UK utility company, might come under government control. This development caused the value of Thames Water debt to plummet, raising fears that investors would incur losses if the company was nationalized.

The situation with Thames Water is ongoing, serving as a clear example of higher interest rates exacerbating existing problems. If the company falls into government hands, it could lead to speculations about other issues in the water utility sector and other highly leveraged industries. This, in turn, would amplify uncertainties and undermine investor confidence in the UK's ability to manage higher rates.

I believe that expectations of rate hikes in the UK are exaggerated, and at some point, there will be a significant drop in market rates when the Bank of England delivers less monetary tightening. The near-term performance of the US dollar is closely linked to expectations of Federal Reserve monetary policy and global economic growth. Key upcoming data, such as PCE inflation, ISM indicators, non-farm payrolls, and CPI figures, will influence the Fed's decision-making. I still see the possibility for this data to provide leeway for the Fed to maintain its current pause.

However, if that proves to be the case, the weakening of the dollar could be limited by falling inflation in other countries (such as Australia and Italy) and uncertainties surrounding growth (such as in China), as well as signs of higher rates impacting the real economy (as seen in the UK). I anticipate that these conflicting forces will keep foreign exchange rates within certain ranges, but I acknowledge that stronger US data next week could change this dynamic and lead to the US dollar outperforming other currencies.

LARGEST 2S10S INVERSION IN ONE MONTH HIGHLIGHTS UK GROWTH RISKS

Source: Bloomberg & Macrobond

JPY: BoJ bar for tightening is being lowered

The yen is currently trading at its weakest level against the dollar since November 10th of the previous year. During that time, USD/JPY had reversed from intervention levels implemented by Japanese authorities to halt yen depreciation. This move was prompted by the initial signs of declining inflation pressures in the US. Many, including my self, believed that this reversal marked the beginning of a sustained turnaround for USD/JPY. However, that hasn't been the case.

While I don't anticipate USD/JPY reaching last year's highs, the monetary policies of both the Federal Reserve (Fed) and the Bank of Japan (BoJ) have created renewed interest in buying USD/JPY. The BoJ continues to advocate for sustained monetary easing, as evidenced by Governor Ueda's solo stance at the Sintra meeting, where he argued that inflation remained too low and unsustainable. The BoJ's position is undoubtedly supporting the Japanese equity markets, which, in turn, help bolster inflation expectations.

Last week, foreign investors sold Japanese equities for the first time in twelve consecutive weeks, resulting in a drop in the Topix Index, including notable foreign selling on Friday with a 1.4% decline. However, the Topix has rebounded this week, and I maintain the belief that conditions are aligning for a shift in the BoJ's stance.

Although Ueda expressed different views from other central bank heads at the Sintra meeting, he presented a potential scenario for a change in monetary policy. He suggested that if the BoJ gains more confidence in its current inflation forecast, which predicts a pickup next year following an expected deceleration in the second half of this year, it could serve as a reason for a policy change. Hence, the threshold for a policy shift is lowering, hinging on the BoJ's confidence in its existing forecasts. In the near term, this confidence would likely be bolstered if the second-half inflation decline is less pronounced than expected.

However, the upside for USD/JPY from its current position is limited. This is not only due to the aforementioned factors but also because of the increasingly vocal opposition from the Ministry of Finance (MoF) regarding further yen weakness. Masato Kanda, the Vice Finance Minister for International Affairs, has made his opposition clear in recent comments. I suspect that once the exchange rate approaches the range of 145-150, the MoF may take action to prevent a breach of the 150 level.

USD/JPY DXY DIVERGENCE HIGHLIGHTS USD/JPY DOWNSIDE RISK

Source: Macrobond

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