FX Weekly

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Fed rate hike speculation fails to strengthen USD

Trade Ideas:

We are maintaining our short EUR/JPY trade idea. .

IMM FX Positioning:  

The latest IMM positioning data revealed that leveraged funds had sharply increased short JPY positions ahead of the recent rebound. A short squeeze has likely reinforced the JPY’s upward momentum this month.

ECB Conference Sentiment Analysis: 

ECB rhetoric remains firmly inflation-focused, with recent communications consistent with a conditional hawkish bias and further tightening risk.

FX Views 

USD: Will Fed policy update prove sufficient to reverse recent sell-off?

The big focus in financial markets over the past week has been the accelerating sell-off in global bond markets driven primarily by the short end of the curve. Looking at the recent performance of major global bond markets in the Germany, Japan, the UK and US, the average yield on 2-year bonds has increased by around 18bps extending the advance since the lows in June to almost 60bps. Yields have also increased at the longer end of the curve but to a lesser extent. Higher energy prices are encouraging the hawkish repricing of short-term rates. The price of Brent and natural gas in Europe have increased by around 50% and 100% respectively since the low points in June. The unfavourable energy price developments will make it more difficult for central banks to look through the energy price shock. Energy supplies through the Strait if Hormuz have been disrupted for over six months now with hopes dwindling for flows to normalize in the near-term.  

So far the spillovers into the FX and equity markets from the bond market sell-off have only been modest. Over the past week, FX price action has been consistent with more risk-off trading. The SEK, NZD and AUD have underperformed while the JPY has been the best performer. The JPY has extended its recent rebound after USD/JPY broke below important support at the 155.00-level, and encouraged by comments from US Treasury Secretary Scott Bessent indicating that the US Treasury’s recent decision to intervene to support the JPY was backed-up by inside information over potential policy changes in Japan.  One policy change we expect in the week ahead will be a faster pace of BoJ rate hikes. Rhetoric from BoJ officials has become noticeably more hawkish since joint US-Japan intervention to support the JPY in at the start of the summer setting up a hike next week. If delivered next week the gap from the last hike would have been three months marking a step up in pace from prior six months gap. A 25bps hike next week is already almost fully priced in, and another year-end. Market participants will be washing closely to see if the BoJ signals that the faster pace of hikes will continue. If the BoJ disappoints, it could trigger a reversal of the JPY’s recent rebound. Our own forecast (click here) is for three hikes by the middle of next year.

Unlike the JPY, the USD has underperformed recently even as the US rate market has moved to price in more Fed hikes. There are a couple of reasons why the USD has failed to strengthen on the back of rising US yields. One is that the US yields have risen less than in other major bond markets. The hawkish repricing of ECB and BoJ rate hike expectations has more than offset building expectations for Fed hikes resulting in short-term yield spreads moving against the USD. The ECB delivered a second hike this week in response to higher energy prices, and signalled that the tightening cycle is likely to extend further. The surprising resilience of growth in Europe  to the energy price shock, and higher energy prices more in line with the ECB’s adverse scenario are increasing pressure on the ECB to raise rates into restrictive territory by heightening the risk of second round inflation effects. A Bloomberg source report revealed just after the policy meeting confirmed that ECB officials expect to raise rates further, with another increase possible as soon as next month. However, market expectations for three more hikes maybe too aggressive. It fits with our updated forecasts (click here) for two more hikes in October and December that would lift the policy rate to 3.00%. A level we would view as mildly restrictive. Bundesbank President Nagel has also stated that rates “might need to go into “mildly restrictive” territory. The ECB’s tightening cycle provides support for the EUR from higher rates as long as economic growth in the euro-zone remains resilient. If evidence begins to emergence of bigger negative terms of trade impact it would increase downside risks for the EUR from the worsening energy price shock.

The second reason why the USD has underperformed recently has been growing unease over attempts from US policymakers to suppress market yields. The USD has remained at weaker levels since the US Treasury announced plans to expand long-term bond buybacks on 19^th August. It was followed up this week by the announcement that the first expended buyback back operation would be tripled in size from USD2 billion up to USD6 billion. Long-term US yields initially jumped higher in response indicating some initial disappointment that the bond buyback was not even bigger. We have estimated a ballpark figure that expanded bond buybacks over a one-year period could total just over USD200 billion assuming the Treasury continues to hold nine operation/quarter and buys up to USD6 billion/operation. However, this is highly uncertainty as it is unclear how long expanded bond buyback will continue and the size of the operation could still be increased further if desired. It compares to long-term debt issuance of USD231 billion in both the current and previous quarter. The expanded Treasury buybacks play into fiscal dominance fears, and have triggered renewed interest in USD debasement (click here) trades over the summer.    

One way to help ease those concerns would be for the Fed to finally take action to tighten monetary policy in response to upside inflation risks. After stronger US inflation data this week and rising energy prices, market participants have become more confident that the Fed will hike rates in the week ahead. It would provide some much- needed support for the USD although may not prove sufficient on its own to trigger a significant rebound. If doubts remain over how much further the Fed is willing to hike rates in the near-term given the close proximity of the US mid-term elections in November, it could curtail USD upside. On the other hand, if the Fed decides to leave rates on hold again to by more time to assess policy, it could trigger a sharper USD sell-off by fuelling fears that they are falling behind the curve in fighting inflation.          

Weekly Calendar

Source: Bloomberg & MUFG GMR

Key Events:

• It will be an important week for central bank policy decisions, with the Fed’s upcoming meeting appearing the most finely balanced. The Fed is now expected to hike rates after stronger inflation data this week, although it is not a done deal. Fed Chair Kevin Warsh’s speech at Jackson Hole indicated that the Fed would tighten policy if confidence in inflation returning to target were to diminish, but he stopped short of signaling that a rate hike would be required as soon as this month. At the same time, higher energy prices over the summer have increased pressure on the Fed to tighten policy. The Fed is also likely to refrain from providing strong forward guidance, contributing to heightened uncertainty over the policy outlook.

• The BoE is expected to leave rates unchanged again in the week ahead, although there could be further evidence that MPC members are moving closer to supporting tighter policy. At the July meeting, the MPC voted 6-3 in favour of keeping rates on hold, with Catherine Mann joining Megan Greene and Chief Economist Huw Pill in voting for a rate hike. We expect a similar voting split this month, although the updated communication may signal a greater willingness to tighten policy if higher energy prices persist. The BoE will also announce updated plans for balance sheet reduction. We expect the annual pace of QT to be slowed from GBP70 billion to GBP50 billion, while active gilt sales remain unchanged at GBP20 billion.

• The BoJ is expected to accelerate the pace of policy tightening by delivering another 25bps rate hike at its upcoming meeting. If delivered, the move would mark a step up in the tightening cycle, coming just three months after the previous hike in June compared with the six-month gap between the prior two rate increases. Recent hawkish communication from BoJ officials has strongly signalled that a further hike is warranted in response to growing risks of an inflation overshoot. A 25bps move is now almost fully priced in, meaning investors will focus primarily on whether the BoJ signals that the faster pace of tightening is likely to continue, leaving the door open to at least one additional hike before year-end.