BoJ signals a hike is coming after weak JGB auction

JPY: Downside risks limited from here  

The US dollar is softer versus most G10 currencies after a turnaround yesterday from intra-day highs with uncertainty over Trump’s attack on Fed independence set to remain a strong deterrent against any sustained buying of the dollar. From the intra-day high yesterday, the DXY index is now down 0.65%. The strength of the dollar yesterday looked somewhat detached from the fundamental news and was likely a reflection of month-end related flows. The US yield curve steepened again yesterday and despite some reversal of that steepening so far today, the 2s10s remains above 60bps, which if sustained today would be the first time it has remained above that level on consecutive days since February 2022.

Negative dollar momentum today is most evident versus the yen and we continue to see scope for declines ahead, highlighted by our current short USD/JPY trade view in our FX Weekly (here). The basis of the view is the anticipated divergence in monetary policy as we approach a period when we expect the BoJ to hike rates while the FOMC has restarted monetary easing. Today BoJ policy board member Junko Nakagawa reiterated the guidance of the BoJ that if the outlook for the economy and inflation are realised then the key policy rate would be increased. Nakagawa sits on the dovish side of the dove-hawk spectrum and hence her comments were balanced but by repeating the important guidance, market expectations of a hike this year have been maintained. With the next meeting on 19^th September, BoJ officials will not want to convey too hawkish a message that would potentially fuel expectations of a sooner rate hike. An October hike looks much more plausible. In any case, key monetary policy signals tend to be conveyed by the senior members of the BoJ and in that context we see the speech from Deputy Governor Himino, scheduled for next Tuesday, as being more important. He may communicate a stronger message that the fundamentals are now in place for a rate hike over the coming meetings.

Nakagawa was likely also extra cautious with her communications following a weak 2-year JGB auction today. The bid-to-cover ratio of 2.84 was the lowest since 2009 and in part likely reflected building expectations of a rate hike to come. The bid-to-cover at the last auction was 4.47 while the 12mth average was 4.01. However, a BoJ rate hike is likely being increasingly viewed as more important in anchoring long-term yields given increased inflation risks.

A 25bp hike in October is still only priced at a little over a 50% probability so we see plenty of scope for front-end yields to rise further. The 2-year JGB yield remains below the high set just before Liberation Day but if as we expect, the BoJ hikes in October, yields will soon be at new highs. The sharp contract in policy moves in the coming months and the uncertainty over Fed independence that continues to steepen the US yield curve all points to increasing downside risks for USD/JPY.  

STEEPER US YIELD CURVE POINTS TO DOWNSIDE RISKS FOR USD/JPY

Source: Bloomberg, Macrobond & MUFG GMR

EUR: French risks escalate  

The OAT/Bund spread blew out further yesterday, breaking above the 80bp-level for the first time since January, surpassing the closing highs set in April during the risk-off episode related to Trump’s Liberation Day tariff announcements. The scale of the move this week (12bps widening) is the biggest move since the political turmoil that began in June last year. We mentioned here on Tuesday that we didn’t see this escalating to such an extent that it impacts the EUR/USD rate, in part given the negative risks on the dollar side were likely to prove more compelling.

In June last year, the OAT/Bund spread widened out sharply from 48bps on 6^th June to a high of 82bps on 27^th June as investors priced in the political risks associated with the snap election called by President Macron on 9^th June. Over the same period EUR/USD dropped by around 2 big figures. In terms of G10 FX performance over that period, the euro ranked in the middle amongst the other G10 currencies. So even in that more extreme scenario, the overall FX impact was relatively muted. Of course no two times are the same and in the context of the advance of EUR/USD this year there is scope for a bigger negative reaction if the political landscape became severe.

But the most likely scenario from here still seems a rerun of what happened in December last year when Michel Barnier was forced to resign due to the failure to get the 2025 budget through parliament. That saw the OAT-Bund spread widen out to the current closing high of 88bps, a level that could certainly be broken in the current episode. It’s seems highly likely that PM Bayrou will lose the parliamentary confidence vote on 8^th September with opposition parties already indicating a plan to vote against. President Macron will then likely look to repeat the same again by choosing another candidate for PM and trying once again. What is clear from this is that France is in policy gridlock and the prospects of any meaningful fiscal consolidation ahead of the presidential election in 2027 are slim.

So fiscal risks are certainly high although we would argue that is not exactly a new realisation and this move wider for the OAT/Bund spread is more a reflection of a positioning flush out after the spread had narrowed through to recent ytd lows. There are some upcoming sovereign rating reviews that could result in downgrades. Fitch Ratings is scheduled to provide its updated review on 12^th September.

From a Japan flow perspective, the political uncertainties last year did prompt a significant sell-off of French debt held by Japanese investors. In fact last year, Japanese investors sold on the most sustained basis on record with selling every month from May through to January this year, with a cumulative JPY 5 trillion worth of long-term debt sales. Since then there has been only a partial reversal of that selling with JPY 760bn worth of buying.

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com