FX Update: Strong US data unsettles the entire market narrative

FX Trading focus:

• USD trades mixed after strong US data pumps long treasury yields higher still.
• Carry trades (long MXN, HUF, BRL, others) versus especially the JPY are under huge pressure, as financial conditions are a stronger focus than normal JPY-US 10yr correlation.

Strong US data yesterday risks entirely resetting the market narrative if confirmed in today’s June jobs report, but more importantly in the coming month or more of additional data. Simply put, the market is poorly positioned for a reheating of the US economy and yesterday proved that.

The June ADP private payrolls change registered an astounding +497k increase, far higher than any pre-pandemic monthly payrolls growth number stretching back to the 2010 beginning of that data series, not to mention far higher than the +225k expectations. The second bit of evidence that the US economy remains at cruising altitude or better was a strong June ISM Services survey at 53.9 vs. 51.2 expected and the 50.3 from May, with Employment improving sharply to 53.1 from 49.2 and New Orders a robust 55.5. Secondary data didn’t support the chief developments, but was seen as less important (initial jobless claims rebounding to 248k and a big drop in the JOLTS job openings survey, although continuing weekly claims continues to drop from the early May highs.)

The reaction function across markets was as interesting as the data itself. No surprise to see the initial US dollar strength as US yields jumped higher, although note that the move at the long end of the yield curve held into today’s session, while the move was partially erased at the front-end of the yield curve (yield curve steepening). Looking across the yield curve, it is remarkable that the market refuses to mark the Fed’s terminal rate higher, preferring instead to remove expectations of rate cuts out the curve and sending the belly and long end of the curve flying. Risk sentiment took the higher yields on the nose, with an ugly correction in US equities and Japanese equities even more so overnight on the firmer (!) JPY – more below.

Next week sees the US June CPI on Tuesday and 3-year, 10-year and 30-year treasury auctions on Tue-Thu. The first real Fed speaker of note could be Christopher Waller of the Board of Governors, who will speak on the economic outlook next Thursday. He is considered one of the more hawkish members. Has the market got the Fed wrong on its potential to hike even more through the December FOMC than the June dot-plot projections suggest (currently priced for 37 basis points more tightening vs. the median +50 bps).

JPY firms as financial conditions tighten
That’s right: the JPY firmed overnight and into today’s session despite the surge in yields at the long end of the key sovereign bond yield curves. The JPY-US 10-year correlation, or r-squared for the last 500 trading sessions is 0.89, just to underline how unusual it is to see these two developments simultaneously. One explanation for yesterday’s action is from a positioning angle: simply that short positioning in the JPY is very aggressive, particularly in carry trades against high-yielding currencies, so that any event that sparks significant general volatility and risk aversion can lead to position squaring in what have been the most profitable trades – like long MXNJPY and CADJPY, BRLJPY, etc. Some of those flows were predicated on the idea that rates were set to fall as EM banks might prove the first to cut rates as growth and inflation ease off. Those flows can overwhelm other considerations (like the prior negative focus on the JPY on rising global yields, especially at the long end of yield curves – continuing to challenge the Bank of Japan’s ongoing easing, etc.). To know the answer, we’ll need some more time, but if US yields continue to rise, I would lean on the yields as the signal that the JPY must adhere to, as long as the Bank of Japan stands pat (USDJPY finding support eventually). One thing to note is that while US and European 10-year yields have jumped aggressively here, the 10-year JGB continues to trade well south of the 0.50% band limit imposed by YCC.

Overnight, we saw May wages data from Japan that showed a 2.5% YoY increase, far above the 1.2% increase from April and last year’s average just above 1.5%, suggesting that the March wage negotiations are beginning to kick in, but there wasn’t much of a market reaction around the time of the data release at 2330 GMT. Bank of Japan Deputy Governor Uchida was out speaking and offered few signs that the July 28 BoJ meeting will bring any policy tweak, noting that there are more risks in going too quickly than too slowly in normalizing policy in an interview with Nikkei.

Chart: USDJPY
So far, the USDJPY consolidation looks like a standard one and doesn’t even begin to threaten the uptrend until it is working south of perhaps 141.00, although a trendline is in play here quite soon. As noted above, there is considerable tension in the JPY and US long treasury yields rallying at the same time – will the very persistent long-term correlation re-establish or is there a greater threat of more JPY upside if financial conditions continue to tighten (carry trades, etc. noted above), even if US yields pull higher still? How USDJPY closes today after the US June jobs report and through next Wednesday’s CPI print.