What Flattening US Yield Curve Means for USD/JPY

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Daily FX Market Roundup 03-26-14

What Flattening US Yield Curve Means for USD/JPY

GBP: Will Stronger Employment Translate into Higher Retail Sales?

EUR: Extends Losses on Weaker French Labor Data

Australian Dollar – How High Can it Fly?

USD/CAD: Fifth Straight Day of Losses

NZD: Trade Balance Tonight

JPY: BoJ Hanging Tight Ahead of Tax Increase

What Flattening US Yield Curve Means for USD/JPY

Despite a sharp recovery in durable goods orders last month, the U.S. dollar traded lower against the Japanese Yen today. Part of the currency pair’s weakness can be attributed to one of biggest stories in the financial market this week which is that the U.S. yield curve is flattening at an alarmingly rapid pace. Earlier this week, the difference between the yields on 5-year notes and 30-year bonds dropped to its smallest level since 2009. Typically yield curves flatten when inflation expectations are falling or investors are worried about slower growth but in this case, short-term rates are rising as long-term rates are falling. Fixed income investors are responding to Janet Yellen’s forecast of higher rates next year because the rise in short term rates reflect the market’s expectation for Fed tightening. The decline in long-term rates on the other hand reflects expectations for a long period of slow growth and low inflation. After hearing Yellen say that rates will rise 6 months after QE ends, many traders needed to adjust their positions in anticipation of earlier tightening. Normally, USD/JPY rises on increased rate hike expectations but the first chart shows how closely USD/JPY tracks the 2 year – 10 year yield curve spread which has fallen but not as steeply as the 5 year – 30 year spread shown in the second chart. Nonetheless the clear correlation with USD/JPY (yellow line) seen in both images suggests that if the yield curve continues to flatten, USD/JPY could be headed lower. A steeper yield curve typically represents an appetite for risk, which is what USD/JPY needs to rally. Unfortunately even with tomorrow’s revisions to Q4 GDP, pending home sales and jobless claims reports, we do not expect the curve to reverse course this week. Investors will have to wait for next week’s ISM and non-farm payrolls reports for any potential change in the course of the U.S. yield curve and USD/JPY.

GBP: Will Stronger Employment Translate into Higher Retail Sales?

While the British pound traded higher against the U.S. dollar and euro on the back of comments from Bank of England member Martin Weale, the sustainability of the currency’s gains hinges on tomorrow’s retail sales report. Consumer spending is expected to rebound in February after falling sharply in January. The recent improvement in labor market conditions supports a recovery in retail sales but according to the British Retail Consortium, spending fell for the first time in 18 months in the month of February. We are not looking for a decline in retail sales but there’s scope for a smaller increase. In January BRC reported a sharp rise in spending while the Office of National Statistics reported a decline, which tells us that the rebound expected in tomorrow’s report could be payback for the previous month’s misalignment. Either way, the retail sales report will be a significant market mover for sterling and could compound it gains if the surprise is to the upside. Today’s rally was driven by Weale’s comment that wage growth is on the rise, which is essential for a sustainable recovery. He also said “Obviously, as the economy recovers, the interest rate isn’t going to stay at half a percent indefinitely.” According to our colleague Boris Schlossberg, “UK officials are clearly starting to think about tightening policy, but any speculation of possible rate hike this year, may be premature unless UK growth re-accelerates” and the key lies in Thursday’s retail sales report.

EUR: Extends Losses on Weaker French Labor Data

The euro extended its losses against the U.S. dollar on the back of weakening labor market conditions in France. While the PMI reports released earlier this week fueled hope that the Eurozone’s second largest economy is recovering, an increase in joblessness raises questions on whether the economy has really stabilized. This is especially true as the number of people seeking full time employment rose to its highest level ever. Without an improvement in labor market conditions, it will be extremely difficult for the economy to recover, which is why reducing unemployment is President Hollande’s number one priority. News that consumer confidence held steady in Germany provided very little support to the euro. The currency pair continues to be pressured by yesterday’s comments from ECB policymakers who warned that negative rates are a policy option. If economic data continues to surprise to the downside, the central bank could become more vocal about their willingness to increase monetary stimulus. With no major Eurozone economic reports scheduled for release tomorrow, euro could remain under pressure.

Australian Dollar – How High Can it Fly?

Investors bought Australian dollars aggressively today, sending the currency to its strongest level in 4 months. From its 0.8660 low set in late January, the currency pair appreciated nearly 7% over the past 2 months. While slowing Chinese growth poses a major risk for Australia’s economy, the Reserve Bank’s decision to shift from an easing to neutral monetary policy bias kicked off the rally in AUD in early February. Since then, signs of improvement in the domestic economy reinforced the central bank’s brighter outlook, giving investors strong reasons to unwind their short positions. The latest surge in the currency was driven by last night’s comments from RBA Governor Stevens. It was not so much what he said but what he didn’t say that sent the currency pair to year to date highs. Having previously expressed a desire to see the AUD/USD closer to 85 cents, Stevens refused to talk down the currency and in fact didn’t overtly mention their discomfort with the level of exchange rate even though it is 7 cents higher than where they would have liked to see it back in December. Even when pressed by a reporter on whether 90 cents is a “line in the sand,” Stevens refused to lock the central bank into an exchange rate target. While every policy making body would prefer a weaker currency in a low inflation, slow growth environment, in the case of Australia, they have become more tolerable of a stronger currency now that the economy is performing better. The RBA still expects the currency to move lower in the long run because of the terms of trade and the prospect of higher U.S. rates. However between their neutral monetary policy stance, improving data, speculation of stimulus from China and liquidation of short positions, investors will be happy to take the Australian dollar as high as 94/95 cents in the near term. According to the most recent CFTC IMM report, speculative short positions were shaved by 35% as of last Tuesday. There’s no doubt that more short positions have been covered and we would not be surprised if positions are currently close to neutral. In other words, we don’t believe that a short squeeze will contribute much more to the AUD/USD rally. However there’s plenty of scope for fresh longs especially if China fast tracks stimulus.

JPY: BoJ Hanging Tight Ahead of Tax Increase

There was very little consistency in the performance of the Japanese Yen today, which traded higher against the U.S. dollar, euro and Swiss Franc and lower against every other currency. We’ve got a lot on the Japanese economic calendar this week but the major economic reports are not scheduled for release until Thursday evening. The only piece of data released last night was the corporate service price index, which held steady in February after a downward revision in January. As measure of inflation, this decline illustrates the long path to 2% inflation for the Bank of Japan. While the central bank expressed very little desire to raise stimulus, according to Etsuro Honda, an adviser to Prime Minister Abe, the BoJ could decide as soon as mid May if further stimulus is needed after the sales tax hike to keep inflation on track for meeting its 2% target. Japanese policymakers are not saying no to additional stimulus but they want to see how much damage the tax increase has on the economy before jumping in with more support.

Kathy Lien
Managing Director

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