FX Update: USD jolted higher on fitful safe haven bid. JPY risks mount.

FX Trading focus: Hard to find any path to sustained US dollar weakening.

The equity market lurched suddenly into risk-off mode yesterday, just two days after one of the strongest rallies this year, showing an unsettling volatility of volatility. In Q1, the market rallied steeply in March, but rolled over starting on the second to last day of the quarter. This quarter, we found a bottom in sentiment right around the FOMC meeting and rallied steeply, only to roll over (so far) on the third to last day of the quarter. Are these portfolio rebalancing effects and are they already fading ahead of the new quarter? In any case, the jolt weaker in risk sentiment offered traditional safe-haven support for the US dollar, which has generally traded since late last year as a function of Fed tightening anticipation.

The USD won’t roll over durably, I argue in our upcoming Q3 outlook, until the Fed is seen as launching into a sustained easing again. So, although yesterday saw a modest apparent safe-haven bid into treasuries, we also had Fed officials out staying on message for further tightening (Cleveland Fed’s Mester: Fed is “just at the beginning” of raising rates) and we have a QT that is on autopilot to continue tightening financial conditions. One key data point that spooked the market yesterday was the huge drop in expectations component of the US Consumer Confidence reading for June, which fell to 66.4 from the revised 73.7 in May (revised down from 77.5!). This is the worst for that data point since 2013 and further inverts the Expectations-Present Situation spread. But we’re not really “there yet” in terms of clear recession unfolding until the Present Situation is moving clearly negative.

Technically, nothing has broken down among USD pairs – the EURUSD has merely shied away from the key 1.0600 resistance and traded back toward the pivotal 1.0500 area, the AUDUSD is having a look at a minor consolidation triangle support, but is still above the 0.6829 cycle low and GBPUSD finally halted its string of days of nearly unchanged daily closing levels at six and lurched lower yesterday, but traded nearly two figures above the cycle lows below 1.2000 this morning.

So let’s wait and see for the next round of data to test USD direction and whether it has potential higher again. The easiest upside path would be US data that proves less bad than expected or even distinctly inflationary on earnings next week (the Citi economic data surprise index for the US is about as negative as it ever has been over the last several years, if we remove the pandemic outbreak months from consideration), together with a fresh leg higher in crude oil, all of which supports the USD from the Fed policy outlook side and safe-haven angle, if risk deleveraging continues . Good data is likely bad for risk and good for the US dollar, while very very bad for the JPY, as discussed below.

Chart: USDJPY
A decent little retreat in US treasury yields, and yet here we are pegged near the highs in USDJPY – possibly ready for an aggravated ascent in coming days if the US data fails to confirm the “recession incoming!” scenario and US yields tick back up higher toward the 3.50% level for the US 10-year treasury yield benchmark, for example. While US yields have remained rangebound recently, we also have to consider the relative balance sheet situation of the two central banks as the BoJ has added to its balance sheet at a record pace recently to defend the yield-curve-control policy and has effectively lost control of its balance sheet in a rising yield environment, while the Fed is set to accelerate the shrinking of its balance sheet (QT) from here. We have a potentially explosive situation on our hands that could lead to a spike higher in USDJPY to well above 140 and possibly even 150, which could then lead to the Bank of Japan to finally capitulate and driving a 10% or greater boomerang move in the opposite direction. Beware volatility potential in both directions!