USD: Higher yields points to upside USD risks

With FX volatility still depressed as highlighted by the MUFG FX Volatility Index hitting the lowest level since pre-covid it seems logical to believe that the only way from here is for FX volatility to spike higher. Risks of a jump in volatility are definitely growing with Brent crude oil through the USD 100-level, yields rising in all major bond markets and AI-related volatility continuing to point to an increased risk that a larger correction in global equities is approaching.

UST bond yields jumped notably yesterday with the OIS market indicating the probability of a rate hike by the Fed next week remains around 35%. Yields in Japan continued to grind higher today even with the underlying core-core nationwide CPI annual increase being slightly weaker than expected at 1.7% in June. However, it is the underlying adjusted measure that excludes temporary distortions from policy changes and other special factors that needs monitoring and that stands at 2.7% in May. The June data will be released next week. Yields are also higher in Japan and globally due to the fears of a further escalation in the conflict over the weekend with Axios reporting that President Trump is considering a “massive attack” and that he was “close to making a decision”. That suggests an attack over the weekend is high. The US dollar buying momentum looks likely to continue into the weekend. A big attack before the FOMC on Wednesday that sees crude oil prices further higher could result in further positioning for an FOMC hike next week. (we see it as very unlikely).

That will ensure Japan remains constrained by what they can do to curtail USD/JPY moving further higher. 1-week implied USD/JPY vol has jumped as the period now covers the BoJ meeting next Friday and while the BoJ will not alter the policy rate, there is an increasing risk of a more hawkish press conference that would then bring September more into play for a hike – currently priced at 9-10bps.

The US Treasury semi-annual report, released yesterday, did not cite any country for currency manipulation but did reference the undervaluation of the yen noting that “monetary policy normalisation would help anchor inflation expectations and reduce excessive rate volatility”. The US certainly wants the BoJ to hike but a continued slow grind higher in USD/JPY will likely continue given the global rates backdrop due to higher energy prices.

US TREASURY HIGHLIGHT JPY UNDERVALUATION IN SEMI-ANNUAL REPORT

Source: Bloomberg, Macrobond & MUFG Research

EUR: Rate support could start to fade

The ECB message yesterday in our view certainly pointed to the prospect of another rate hike in September (FX Focus reaction piece here). While the statement acknowledged that energy prices remain close to baseline assumptions, the comment that the “full inflationary impact of the energy shock has yet to play out” gave some balance with concerns still elevated over achieving price stability. Bloomberg released one of its sourced articles (from people familiar with the matter) confirming a hike in September unless the inflation outlook improves “markedly”. The fact that some Governors considered whether a hike was needed yesterday reinforces the prospect of a September hike. Who knows how the Middle East pans out but even if crude oil prices start to decline again, we are unlikely to see a marked improvement in the outlook by then and hence a hike from the ECB is very likely, consistent with our call. That’s close to fully priced now.

The US dollar gained broadly yesterday but we certainly see increased downside risks for the euro and the pound if the energy markets continue the current pace of increases. One energy space that looks increasingly different is the natural gas market with prices surging and are already have hit the peaks in March. Winter shortages are an increased concern with storage rates in Europe already lower than average and refilling potential now impacted again. Natural gas price rises have a more direct impact on household incomes that can feed through into weaker consumer spending and growth. We are nowhere near the gains during the starting period of the Russia/Ukraine conflict, but the speed of increase can impact sentiment. In Europe from the close toward the end of June natural gas prices are up over 50% while in the US over the same period prices have fallen 15%.

Rate hike pricing is becoming more aligned between the Fed, ECB and BoE but investors are likely to see the US being better able to manage the potential hikes as currently priced. Today, the advance PMIs will be released, and we may see continued divergence with Europe’s readings in the sub-50 area while the US remains in expansionary territory. The US economy looks better placed to deal with this latest geopolitical risk upturn and if confirmed in the data will likely see this US dollar move stronger extend further.

Momentum points to further gains for the US dollar while technically the clearer break of 1.1400 in EUR/USD adds to short-term bullishness. The previous high for DXY at 101.80 is now in sight and a break there would be another bullish sign. Short-term risk reversals in EUR/USD have also broken lower as demand for downside protection picks up as investors start to price for a further escalation of the conflict.

NATURAL GAS PRICE SURGE IN EUROPE AS PRICES FALL IN THE US

Source: Bloomberg & MUFG Research