The USD/JPY has fallen sharply since the beginning of August which has weakened its correlation with risk. Equity markets have been in a sustained bull trend since June and haven’t shown any signs of wavering.
USD/JPY
The USD/JPY has fallen sharply since the beginning of August which has weakened its correlation with risk. Equity markets have been in a sustained bull trend since June and haven’t shown any signs of wavering. The divergence has seen risk sentiment’s explanatory power for the pair fall to 45% from 53% a month ago. The dollar has started to replace the yen as the funding currency of choice which has made predicting yen movements tricky. The Asian currency traditionally has a negative relationship with risk as the BoJ maintains rates at very low levels in order to stimulate demand for exports. Therefore, the local currency has almost no relationship to interest rate expectations as its correlations stands at -0.051. However, a new political regime may alter that as the DPJ touted the benefits of a strong Yen on the campaign trail. On the other side, we are seeing that U.S. policy decisions are starting to have a greater influence on price action as potential tightening from the FOMC would alter the greenback’s status as a funding currency.
BoJ Interest Rate Expectations
The BoJ is expected to be the last central bank to begin tightening as the country’s rates were already near current levels before the credit crisis led to global easing. Therefore, markets are pricing in less than 10 bps of rate hikes over the next twelve months for the island nation. A new political regime does raise some questions regarding future policy. The new Finance Minister Hirohisa Fuji has already stated that he doesn’t support a weak yen. Additionally, the Democratic c Party of Japan’s victory will usher in a new way of thinking as they said during the campaign, that a stronger yen will boost household spending by making imported goods less expensive. That’s in contrast to the former administration’s focus on keeping the yen weak to help exporters. Therefore, we may start to see interest rate expectations rise and in turn its influence on price action.
FOMC Interest Rate Expectations
Fed funds futures are currently pricing in a 4.6% chance of a rate hike by the end of the year. The dollar has continued to trade on risk sentiment without the threat of tightening from the FOMC. This has given rise to the greenback’s prominence as a funding currency. Therefore, a rise in interest rate expectations could usher in a return of fundamentals as a driver of price action for the dollar. Policy makers will meet tomorrow and if they hint at future tightening, we could see the relationship between U.S. interest rate expectations and the USD/JPY significantly increase.
Risk Appetite
Equity markets are finding support today on the back of improved growth outlooks for Asia and Switzerland adding to optimism that a full blown global recovery is underway. Typically, we would see the USD/JPY rise given current conditions but its current weakness adds to the case that the greenback has replaced it as the funding currency. Traders continue to ignore concerns that current valuations may be outpacing the scope of the recovery. However, we still remain below pre-Lehman collapse levels which are where we may need to reach to curve risk appetite.
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