Monumental week ahead for status on JPY, Trump tariffs, US jobs.

What’s going on: sterling and JPY weak, ECB hawkishness fails to inspire Euro

Volatility has declined across markets this summer, including in foreign exchange, with USDJPY and EURUSD 1-month implied volatility hovering near the low of the range of the year at 9.6% and 7.5%, respectively. These aren’t particularly low levels historically, but in today’s uncertain world feel rather low. Strong global risk sentiment and low vol has allowed the JPY carry trade to thrive and pushed EURJPY, for example, to within striking distance of its all-time high of 175.43 from July of last year – completely unfair if we look at EU-Japan yield spreads, which haven’t been relevant for ages but still stick out like a sore thumb. More in the chart below. Elsewhere, EURUSD posted a meaningful low last week near 1.1550 while I was away on holiday, the USDJPY is rangebound in a vast 142-150 range.

Elsewhere, AUD managed a new high above 0.6600 this week for the first time since November of last year and then promptly spoiled that by backing into the recent range, keeping the impression of an impossibly choppy rising channel in place for now. Sterling has been very weak, with GBPUSD possibly in head-and-shoulders mode if it revisits the 1.3365 area “neckline”. Sterling weakness is remarkable given a supportive backdrop of extremely complacent risk sentiment – the currency could be in for a crisis if we for any reason we lurch into a risk-off environment – recall the sterling dynamics in April!

Next week presents a huge menu of event risks. These could surprise in either direction, but my overall stance for the week ahead is that broad risk sentiment is extremely complacent, and my bias is for a JPY snapback rally at some point soon – certainly next week if the event risks line up in favour of the trade, but even to fade JPY weakness even if the event risks fail to line up for the yen.

Chart: EURJPY
Breaking: just after publishing today's update in its entirety, the news crossed the wires that an LDP member has gathered the votes in both house of Japan's diet to call a joint meeting - suggesting a rebellion in the ranks to force PM Ishiba out, who apparently is resisting calls to resign. This is pressuring the JPY lower.

Recall that last year, the JPY carry trade came undone in spectacular fashion around this time of the year, with USDJPY collapsing quickly after its July peak on a soft US CPI print on July 11 and then accelerating on July 31 on the one-two of a hawkish BoJ and dovish Fed. It’s a bit of déjà vu this year as we have both the Fed and BoJ next week, though we don’t have the JPY strength or much likely potential for a hawkish BoJ. This time around, EURJPY has outperformed USDJPY as the USD has weakened and portfolio allocations, including by Japanese investors, have rotated in Europe’s favour this year. This has taken the EURJPY pair to within striking distance of its all-time high since the introduction of the euro at 175.43 a year ago. There isn’t much for the bears to go on for a bearish reversal here outside of minor momentum divergence, but the pricing looks structurally wrong relative to interest rate spreads and the admittedly useless purchasing power parity. With key event risks coming in next week and the JPY at a massive low on widespread complacency and carry trading and no confirming factors to justify this weakness (outside of long Japanese yields forcing a change of approach by Japan’s MoF in “twisting” its issuance to avoid pressure at the long end – but this problem is vastly larger for the US and Japan has perhaps the most firepower in its Net International Investment Position (NIIP) to do something about this of any major economy! Again, it will take a tremendous downdraft to reverse the bullish trend here, but the trend could come unwound in rapid fashion on a shift to the negative in global risk sentiment in coming weeks. The Thursday Bank of Japan meeting next week is a key potential trigger, as discussed below.