Two key events are dominating the FX world this morning: the first is the Reuters report that the Bank of Japan will alter its stimulus programme. The yen is the top performing currency in the G10 this morning, which reverses a month-long period of weakness for JPY.
The report suggests that the BOJ is looking at ways to reduce its footprint in the markets, the bank currently has a target to increase its bond holdings to 10 trillion yen a year. Considering the yen is currently the largest of the major central banks pursuing such an aggressive QE programme, this is big news. However, the impact on the yen could be short-lived. Firstly, the report did not suggest that the BOJ will aim to normalise policy, and thus end QE altogether. Although the 10-year Japanese government bond yield has surged by 56 basis points since the report surfaced, this is still below the high of the year when the 10-year yield reached 1% on 1 February.
Secondly, although the Bank of Japan appears to want more flexibility when it comes to its stimulus programme, and may remove its bond-buying target at its next meeting, we still expect the BOJ to keep interest rates in negative territory after lowering its inflation outlook earlier this year. With rates in negative territory, it is hard to see how far the yen can rally.
Trade wars could keep yen in check
Lastly, outside forces may also weigh on the yen. The Japanese economy is exposed to global trade wars because of the importance of global trade to its economy – both exports of its goods and imports of raw materials that it needs including oil. Thus, with trade wars still a major theme this summer, we may see the yen struggle to maintain today’s rally if we see further upticks in the rhetoric from the US or China.
Bargain hunters starting to emerge
The spike higher in USD/JPY volatility is justified today, however, we don’t expect to see USD/JPY volatility back to the February highs anytime soon, even though we may see volatility in the yen drift higher as we wait for next week’s BOJ meeting on 31/7. USD/JPY has taken a sharp tumble today, and extended Friday’s losses dropping as low as 110.75 earlier, which is ahead of the 50-day sma at 110.50, a key support level. However, the yen is already showing signs that it may be in recovery mode, and is back above the 111.00 level as we head into UK lunchtime.
This suggests some USD/JPY bargain hunters are starting to emerge and some in the market are doubting just how aggressive the BOJ will be when it comes to scaling back its QE programme. We tend to agree with the market, and expect the BOJ to tread a very careful path when it comes to policy changes in the coming months due to the external threats to the economy from a global trade war.
Although a big change to the BOJ’s stimulus programme is likely to materialise, we still think that lose monetary policy is the order of the day at the BOJ for the foreseeable future. However, the risk is rising as we lead up to next Tuesday’s BOJ meeting. We expect yen volatility to remain elevated compared to last week’s levels, and for the yen to trade in a choppy fashion. We would expect USD/JPY to trade in a 110.50-112.50 range in the lead up to next week’s meeting.
Chinese Yuan: how low can it go?
The second key theme in FX right now is the Chinese yuan. It continues to fall after the Chinese authorities injected cash into the banking system, a sign that the PBOC is keen to loosen monetary policy at the same time as the rest of the world is actively tightening policy, or at least starting to think about it.
Beijing: the ultimate way to annoy Donald Trump…
Offshore renminbi spot is now at its lowest level since June 2017. We do not expect the Chinese authorities to intervene to stem the yuan’s decline unless we see a pic- up in volatility and a disorderly crash in the yuan, which is not currently expected. Thus, Donald Trump’s complaining about the Chinese currency may do more harm than good. One way China could punish the US in a trade war is by allowing its currency to continue to slip, thus making US exports to China expensive and less attractive, hurting Trump’s efforts to reverse the US/ China trade deficit. Thus, the next frontier in a global trade war could be a currency war. However, with the Chinese economy under-performing the US‘s right now, a challenged banking sector, and signs that the PBOC may want to loosen policy, we believe a currency war between China and the US is likely to be won by Beijing.
The Chinese authorities may not get too worried about yuan weakness until we see 7.00 vs. the USD, which would be the weakest level since the end of 2016. Thus, a weaker yuan could be a theme in the FX market for some time. A weaker yuan has implications for other Asian currencies who not only want to import goods to China, but who also compete with China on the export markets. There is pressure for Asian currencies to follow the yuan lower, and it is no surprise that Asian currencies dominate the worst-performing emerging market currencies since the start of June, as you can see below. While the yuan continues to fall, we may see further weakness in the Malaysian, Indonesian, Taiwanese, Thai, and South Korean currencies.
Overall, Asia is the centre of the FX action right now, and we expect it to remain so while we lead up to next week’s BOJ meeting. China’s faltering currency may also trigger a race to the bottom in the Asian FX space, which is another reason why we believe that the BOJ will need to be extremely careful to make sure that its next steps do not trigger a wave of yen appreciation in the coming weeks, at the same time as its Asian FX counter-parts continue to see currency declines.
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