FX Update: Could market front-run next Fed move despite FOMC non-event tonight?

FX Trading focus: JPY touchy as EU, US yields on the rise again ahead of FOMC tonight

Rising US yields caught the market’s attention yesterday, a development that has followed through today and seen a significant rise in core EU yields today, as I cover below in the discussion of what has driven EURJPY higher today. The proximate trigger for the jump was theoretically the result of the 7-year US Treasury auction yesterday, although its metrics didn’t show any deterioration relative to the prior auction. Rather, I wonder if the market is front-running the Fed’s eventual need to taper as I discuss in the FOMC preview below.

In an case, the ever yield-hypersensitive JPY was the chief mover on the back of US yields yesterday and US- and EU yields higher today and that will likely remain the case until a) US real yields fail to continue tracking the rise in US nominal yields and b) if the ECB were to bring a similar indication of an explicit yield cap, a move that looks too bold and unnecessary for an EU economy that is on the cusp of opening up in the months ahead and where the manufacturing sector is already on fire (EU flash Apr. Manufacturing PMI registered 63.3, highest for the cycle).

Elsewhere, the Australian dollar wilted on a much weaker than expected Q1 CPI, but less than one might have thought likely, given that iron ore and copper finally consolidated a bit after their recent relentless rise yesterday. Too early to draw conclusions on AUD and AUDUSD, as I suspect the market – outside of JPY – is largely waiting for the FOMC for next steps.

FOMC – market to “react” despite no new guidance?
There is significant speculation that the Fed is going to have to move far faster to indicate a taper of asset purchases than it thought was likely before. And perhaps this is true: another several weeks of collapsing US weekly claims numbers in the US would likely begin to wear on FOMC members’ nerves, as would a hefty CPI print for April and May, their declaration of “transitory” inflation notwithstanding (but it would be the combination of a labor market vastly improving that is likely the key, as inflation alone would take far longer). There are widespread reports of “negative unemployment” in many places in the US, where especially lower-paid jobs can’t be filled as benefits recipients are happy to sit on their stimulus checks and benefits (not set to run out until September).

Bottom line: I am fairly convinced, together with consensus, that the Fed is going to make another show of its commitment not to alter guidance just yet, with no mention of a timeframe for tapering or any other notable hint in tonight’s policy statement, touting the desire to wait for outcomes rather than anticipating them beforehand. Then again, yesterday’s move in US treasuries suggests to me that the market may be willing to front-run what it thinks is coming at the next meeting anyway – so we may get a Fed that says virtually nothing but a fairly strong market movement in the wake of the meeting anyway if the market is hot to price in the Fed's eventual taper-capitulation some time over the summer.

If the above scenario plays out, US treasury yields would likely run higher again. And that would theoretically be USD supportive, and likely would be at first blush in USDJPY, but we will also have to keep an  eye on yields elsewhere and the spread to the US yields (Bunds, etc.) , as well as whether real yields are failing to keep up with new nominal yield rises in the US, which would prove less USD supportive than the last cycle of yield rises from the beginning of this year. Another factor is the degree that any new rise in yields unsettles risk sentiment and how EM- and commodity currencies react to that.

Chart: EURJPY attacks new highs as Bunds at cycle high yield
While US treasury yields were the focus late yesterday, the rise in yields across the EU, and in particular in Bunds deserves attention here as Bund yields rose close to their cycle top near the -20 basis point level (there was a previous double top in yields at the beginning of the year and just after the pandemic panic last spring a bit higher at -15 bps – but safe to say that this is key territory for the Bund. A break above there and follow through higher for EU core yields can really start to buttress the fundamental support for the EURJPY rally, assuming real yields are not in play and only the simple fact that the BoJ has declared a cap on 10-year JGB’s at 0.25% while the ECB only complains when yields rise (that could change, of course, but the ECB is doing plenty already and the EU economies are set for opening up in the months ahead).