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FX: The USD smile and the JPY dam break

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John Hardy

Head of FX Strategy

Summary:  Q2 brought a reacceleration of central bank tightening expectations, as impact of the bank turmoil from March faded quickly. The USD is on its back foot as global markets continue to celebrate an eventual Fed rate peak and steady long US yields. On that note, USD shorts are set for a vicious reality check if the US economy remains resilient and core inflation remains sticky, possibly engaging both sides of the "USD smile" that drive USD strength: the Fed on the warpath and market turmoil. And the stakes are even higher for the Japanese yen if the longer yields of the major sovereign yield curves have to price in a new economic acceleration, as the BoJ will have to eventually capitulate on its yield-curve-control policy.

We composed our Q2 quarterly update in the thick of the fallout just after the March banking turmoil. The cratering of investor confidence at the time and the belief that this would bring forward the end of the central bank tightening cycle due to in incoming credit crunch wrong-footed many, including this analyst. Instead, as core inflation levels nearly everywhere have proven sticky and economies largely resilient, global central banks have largely continued and even resumed tightening rates. As of late Q2, forward expectations for the Fed policy "terminal rate" have crept back close to the cycle highs from early March, before Silicon Valley Bank's collapse. Elsewhere, two G10 central banks, the Bank of Canada and the Reserve Bank of Australia, abandoned the pause in their tightening cycles and resumed hiking rates in Q2. So yes, the banking turmoil was a milestone pointing in the direction of further tightening on credit that will eventually lead to an economic slowdown, but it looks like “eventually” will prove much further over the horizon than we anticipated.

The most extreme example of a reacceleration in forward tightening expectations in Q2 was for the Bank of England, which reported an alarming spike in core inflation to a new cycle high of 6.8% in April with the market pricing BoE tightening to continue through early 2024. And yet global risk sentiment continues to soar, as markets apparently continue to believe in a Goldilocks soft landing of disinflation and no recession, or at least an extremely shallow one. That's the only way to interpret strong risk sentiment in an environment of increasingly inverted yield curves.

The USD to smile and potential USD strength in Q3

Indeed, the markets remain reluctant to believe that inflationary dynamics and the economic cycle will extend much longer and were quick to celebrate the June FOMC rate tightening pause from the Fed, even as Powell and company penciled in two more rate hikes for later in the year. Powell's declaration of data dependency in the press conference at that meeting has set up markets for a wild ride in Q3 and Q4 on incoming data releases. The market will be poorly prepared for resilient inflation and activity data and for any ensuing need to reprice the Fed.

This brings us to the "USD smile", a rule-of-thumb model for what drives the US dollar. The one side of the smile is the USD rising when there is any major form of global market turmoil. When markets are stressed, investors run for safety and scramble for the US dollars needed to service USD-denominated assets, which dominate global liquid assets. Once the Fed intervenes with sufficiently forceful easing to calm markets, the USD retreats.

The other side of the smile that drives USD strength is any aggressive rise in US yields, especially at the front end due to Fed tightening (especially 2022, but arguably also 2015, when the contrast of slow Fed tightening with other central banks was great). A USD smile driven by long US treasury yields rise as well (for example, most traumatically from one moment to the next in the 2013 "taper tantrum" and again when both the Fed and market forces took the entire yield curve higher in 2018 after the Trump supply-side tax reforms of the prior year).

The middle part of the smile is when there is no significant turmoil or when the Fed is not providing any drama. This allows USD direction to yield to external factors and generally means a weaker USD. For example, once the bulk of Fed tightening was priced by late 2022 and long US treasury yields had peaked (well ahead of what was the peak (so far!) at the front end of the curve this March), the USD eased off and more notable developments elsewhere could take center stage. In the case of late 2022, those developments were the ECB coming in more forcefully with tightening. Later, AUD, CAD and GBP grabbed the spotlight on the notable adjustment in policy expectations noted above.

In Q3, our belief is that markets are overconfident in benign outcomes for inflation and therefore for central bank policy. This could engage either or even both sides of the USD smile: sticky inflation and a drum-tight labor market could force the Fed to continue hiking far more than the market imagines as we leave Q2. The most dramatic scenario would be renewed strength in the economy, as this could trigger an unmooring of longer US treasury yields. With global risk sentiment in near euphoria as of late Q2, we're watching the 10-year US Treasury benchmark, which would threaten a reality check and boost the USD as well on a move to new cycle highs. Sure, as long as incoming data cooperates with the disinflation and soft landing and anchored long US yields narrative, the USD can weaken, but beware the USD smile if the music changes.

Waiting for the Bank of Japan dam break

Broad measures of JPY in late Q2 show the currency edging toward the record modern lows posted last fall, even as the weaker USD has meant that USDJPY has yet to challenge the cycle highs. The most obvious driver of the weaker yen in Q2 was the fresh widening of policy spreads, as central banks elsewhere continued to tighten, while the Bank of Japan remains unmoved with its -0.10% policy rate and +/- 0.50% band on 10-year JGB's, or yield-curve-control. Our belief that the economic growth and hiking cycle could extend from here would prove a real challenge for the Bank of Japan and for the very stretched JPY valuation.

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