Head of FX Strategy
Summary: US treasury yields have cranked higher, with the long end of the US yield curve even posting new decade-plus highs in yields. The JPY is playing its usual hyper-sensitive role to yield developments, with EURJPY even posting a new post-2008 high today before retreating sharply today as bonds found a bid. But the yield and yen moves are merely a distraction ahead of a possibly critical message from Fed Chair Powell at the Jackson Hole conference on Friday.
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Yesterday saw an odd combination of a pop higher in US treasury yields and strong risk sentiment, which meant the US dollar was largely sidelined, while JPY crosses hopped and danced with the surge in yields, a surge that was partially unwound in today’s trade. Longer US yields even managed to post new decade-plus highs before retreating today. It is quite clear that JPY crosses will main mono-obsessed with the direction in long global yields unless the Bank of Japan is willing to take further policy-normalization steps, something that might yet become more urgent if USDJPY advances to 150+ again. Until then, while the JPY and yield moves are important technically, the main event is this week’s Jackson Hole, Wyoming symposium hosted by the Kansas City Fed and featuring a Fed Chair Powell speech on Friday - discussed below.
EURJPY managed to scratch to a new post-2008 high yesterday well above 159.00 before retreating today as both US and European yields retreated after US 10-year and longer yields posted new highs for the cycle (and since 2007 in the case of the 10-year treasury yield benchmark). The yen seems destined to remain tightly linked, with negative correlation, to the swings in global yields as Japanese yields might even remain low-beta to global yields in the event of further BoJ policy tweaks. The EURJPY in the longer term picture looks egregiously over-extended, and do note the divergence in the MACD, although we need to at least see a sharp tumble down through 157.50 to suggest the rally is faltering/reversing.
It’s been years since the annual Jackson Hole symposium hosted by the Kansas City Fed has generated as much attention as this year's powwow. The theme this year is “Structural shifts in the global economy”. Not particularly specific, but some possible big hints, given the massiveness of the topic. Is the title meant to suggest an update of the remarkable ECB President Lagarde speech back in April titled “Central banks in a fragmenting world.”? That speech got far less attention than it deserved. In it, Lagarde outlined a number of geopolitical developments that required the central bank’s attention, most importantly the need for the central bank to support investment that lowers the risk of supply shocks stemming from an increasingly fragmenting world (Covid having laid bare the excess reliance on China for supply chains and the Russian invasion of Ukraine making Europe’s energy supply chains suddenly so fragile and more expensive). The paragraph below is perhaps the most crucial one in that speech:
"For example, if fiscal and structural policies focus on removing supply constraints created by the new geopolitics – such as securing resilient supply chains or diversifying energy production – we could then see a virtuous circle of lower volatility, lower inflation, higher investment, and higher growth. But if fiscal policy instead focuses mainly on supporting incomes to offset cost pressures (in excess of temporary and targeted responses to sudden large shocks), that will tend to raise inflation, increase borrowing costs and lower investment in new supply."
What would a Fed Chair Powell speech equivalent of this speech be this Friday (1405 GMT)? Something along the lines of the same: supporting US fiscal objectives which are largely intended to avoid excessive reliance on China/Taiwan for strategically important goods, most notably semiconductors. Those are the Biden administration’s Inflation Reduction Act and CHIPS and Science Act, which are remarkable in helping to drive expanding deficits at a time of virtual full employment. At the same time, the Fed has to at least hint that it is considering the elephant that everyone knows is in the room: unsustainable debt dynamics that will quickly worsen with these high deficits (which will only worsen further in a recession) and as new treasury issuance rolls into higher yield territory.
What to do then? The old answer would have been to stop quantitative tightening and restart QE. But this is not yet acceptable when the inflation dragon has yet to be slain and labor markets are so tight. Rather, there is wide-ranging speculation that the Fed could be preparing the market for policy shifts that improve the demand dynamics for US treasuries in order to at least delay the spiraling risk of higher long rates due to “fiscal dominance”. This paper has gotten considerable attention on that front and suggests that lower interest on bank reserves to zero would help stave off a rising rate spiral by forcing banks to pay less on deposits, thus both lowering bank earnings and effectively taxing depositors with “real losses” via an inflation tax as banks can’t offer attractive yields on deposits. This would also encourage depositors to buy treasuries directly themselves. Market outcomes: hard to discern, if we get clear policy signals confirming the above, it is likely very bad for banks and possibly economic growth, but could also mean lower long yields – so most bullish for the yen?
Others see the Fed taking its longer run Fed policy rate projections higher (the projections published in the Fed’s quarterly “dot plot”). On that front, a Wall Street Journal op-ed from “Fed whisperer” Nick Timiraos put out over the weekend was titled “Why the Era of Historically Low Interest Rates Could Be Over” and argued that higher productivity and higher deficits are possibly set to reset the Fed’s attitude on the appropriate longer term policy rate. The hawkish surprise on this front would be language hinting that the September FOMC meeting will deliver a bump in the longer run rate projections, even if there is no pushback against the notion that is mostly priced that the Fed has reached its terminal policy rate for this cycle. Since 2019, the median longer term rate projection has been pinned at 2.5%. Market outcomes: A rise in the longer run rate projections would be the scenario most likely to deliver USD strength and risk-off.
The ”boring” scenario would be a discussion of the above without any solid takeaways or hints on either longer term implications or what the Fed is set to deliver at the September FOMC meeting. Market outcomes: the US dollar and other currencies will revert to their usual correlations with risk sentiment/China and yield direction.
The USD and GBP strength (the latter on BoE leading the tables on further hike projections), while the smaller G10 currencies are still dragging on the weak risk sentiment up until yesterday’s and today’s huge surge. As noted above, the Jackson Hole conference has considerable potential to reset the narrative in the short term.
Sterling pairs look notably extended, with GBPUSD the only notable USD pair not firmly in USD rally territory (arguably together with USDCHF). The AUDNZD pair can’t make up its mind as it continues to triangulate.
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