Reality sets in as inevitable doubts lead to some US dollar recovery

USD: Fragile truce means fragile risk sentiment

The US dollar is broadly stable so far in today’s trading after strengthening modestly into the close of trading yesterday as doubts quickly emerge and the questions we posed here yesterday remain unanswered. The most pertinent one we posed – if Israel continues to bomb Lebanon will Iran remain at the negotiating table? – looks the most crucial with this element tied to the renewed flow of traffic through the Strait of Hormuz. As of now the Strait of Hormuz remains effectively closed and because of that the entire ceasefire remains tenuous. But while the US dollar has rebounded, the moves in general have been modest, the retracement of the equity market rally in Asian trading has also been small with crude oil prices up by less than 3%.

Key to only these modest retracement moves of yesterday’s price action is the fact that as of now the talks scheduled for Pakistan will still go ahead. Vice President JD Vance will lead the US delegation while it is becoming clearer by the day that Mohammad-Bagher Ghalibaf is where a lot of power now lies within Iran and he will likely be key in determining who leads the Iranian delegation. Foreign Minister Abbas Araghchi posted on social media that the US must choose between ceasefire or continued war via Israel. President Trump has stated that all military assets and personnel would stay in the region until the “REAL AGREEMENT” fully reached is complied with.

There certainly seems considerable distance between the sides at this juncture that leaves expectations low of a dramatic improvement in the current status any time soon. The US could pressure Israel to end its attacks on Lebanon, a step possibly being anticipated by Israel given the escalation in attacks since the ceasefire was announced. The US also claims Strait of Hormuz traffic is picking up which if confirmed in data would ease upward pressure on crude oil prices. However, Bloomberg high frequency data as of yet does not show any compelling evidence of a pick-up.

From the lows yesterday, the 2-year UST bond yield has drifted higher by about 6-7bps as doubts over the ceasefire intensify. The minutes from the FOMC meeting in March were also released yesterday The overall tone and key takeaway from the minutes was more hawkish and while concerns over labour market conditions were cited the emphasis and broader agreement (the “vast majority”) was on the fact that it would now take longer for the Fed’s inflation goal to be achieved and the risk of inflation running “persistently” above target had increased.

Whatever way the conflict unfolds over the coming days and weeks, we doubt relative monetary policy dynamics will be a driver of US dollar strength. However hawkish the Fed may need to become, it seems very likely that the ECB and BoE will be then even more hawkish. The US dollar’s best prospect of appreciation remains a more pronounced period of risk aversion that sees a flight to the dollar. But the general more modest gains for the dollar through this conflict to date we believe is indicative of poor underlying fundamentals for the dollar that will reassert themselves again if we do see further de-escalation in the coming weeks.

DXY & DXY SPREAD CORRELATION HAS BEEN THE WEAKEST IN YEARS

Source: Bloomberg, Macrobond & MUFG GMR

JPY: Heavy bond selling by Japanese investors

The ceasefire deal was very much in focus yesterday with bond yields retracing further after hitting highs toward the end of March – the UST bond 10-year yield hit a closing high of 4.43% on 27^th March, the highest level since mid-July last year.

What we now know following the release of cross-border flow data from the MoF in Japan is that Japanese investors were very much part of the bond market sell-off in March. Indeed, Japanese investors were actively selling in February too, ahead of the Middle East conflict beginning. The MoF data, released yesterday, revealed Japanese investors sold JPY 3,757bn worth of foreign bonds in March after selling JPY 3,422bn worth in February. The combined two-month total selling of foreign bonds was JPY 7,179bn, the largest selling on record over that period. While yesterday’s data does not yet show which foreign bonds were sold, we know from other data that US bonds nearly always make up a significant proportion of the flow. So Japan was likely an active seller of UST bonds but EGBs could also have been a notable proportion.

What is somewhat unusual is that the February selling coincided with a strong bond market rally – the 10-year UST bond yield fell 35bps in February. Selling then continued, for more obvious reasons, in March when the 10-year yield jumped 50bps to the peak on 27^th March as inflation fears over the Middle East conflict escalated. An added factor in the scale of selling by Japan is the fact that this period covers the final two months of the fiscal year. We do know from yesterday’s data the breakdown of what investor type were the main sellers and Japanese banks conducted the majority of the selling – 65% of the total over the two months. Japanese life insurance companies were the next most active sellers. Fiscal year-end considerations therefore likely played a role in the selling, possibly in particular in February. A higher than anticipated USD/JPY level in addition to the strong rally likely encouraged profit-taking by banks while for life insurance companies, the holdings may have been running ahead of the planned asset mix and also encouraged foreign bond sales.

Usually, you would expect to see these sales be followed by notable buying as the new fiscal year unfolds but these are not usual times and hence it will be interesting to see whether Japanese investors will have the appetite to resume buying quickly. While bond yields have fallen dramatically on the ceasefire, uncertainty is high and the ceasefire is fragile. Might this be a time when we see greater proportions of that selling recycled back into Japan’s domestic bond market? Yields are certainly more attractive especially when FX hedging costs are incorporated.

We would expect to see this emerge in the Trust flows incorporating pensions funds like GPIF. Trusts did sell foreign bonds in March, totalling JPY 601bn. Prior to that the flows show persistent buying of foreign bonds versus selling of foreign equities. There is certainly very little evidence yet to suggest Japanese investors are turning more toward JGBs but the scale of foreign bond buying in the coming months after a record two-month period of selling will be another gauge to assess possible shifts.

JAPAN BUYING/SELLING FOREIGN SECURITIES – FEB-MAR COMBINED WAS A RECORD FOR FOREIGN BOND SELLING

Source: Macrobond, Bloomberg & MUFG Research

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com