USD/JPY In The Cross Hairs

The increasing chances of a pause in Fed interest rate increases, underscored by Chairman Powell's latest comments, mean the dollar will get its comeuppance for last year's broad rally, and nowhere will that be more apparent than against the yen.

In historical terms, the dollar is currently the most over-valued major reserve currency, on a long-term real effective exchange rate (REER) basis.
By the same measure, the yen is the most undervalued in that group.

Also, the Fed's campaign of rate hikes through December 2018 took the divergence in monetary policy between the Fed and the Bank of Japan to extremes.
However, even with the support that provided the dollar, USD/JPY lost ground for the third consecutive year in 2018 as it surrendered more of the recovery it started in 2011.

Depriving the dollar of the fuel of continuing hikes -- with the possibility of cuts even -- leaves the dollar vulnerable to reentering the multi-decade downtrend against the yen that was interrupted by the 2011 Tohoku quake-related disasters and the extreme easing response of Abenomics that included vast deficit spending financed by BOJ quantitative easing and negative rates.

If losses in the U.S. currency begin in earnest, there is a risk that the yen could strengthen to less than 100 per dollar this year or next.

PRECARIOUS DOLLAR

The fact that the dollar is so over-valued, based on REER, increases the potential damage from the apparent shift by the Fed and the reversal of policy divergence.

The Fed has been tightening policy since December 2015, including more recent quantitative tightening.
Despite substantial easing in the post-crisis era, the Fed never took its main policy rate below zero.
The BOJ did, however, in February 2016 -- which increased divergence and, now, the potential for convergence.

The Fed's current 2.5 percent Fed funds rate gives it some room to cut rates if the need arises, to the potential detriment of the dollar.

By contrast, the BOJ's stagnant -10bp policy rate and yield curve control program that centers 10-year JGB yields around zero is already adding to the woes of Japanese banks and forcing Japan's aging investor class to take on greater risk at a time when capital preservation ought to be emphasized, particularly given Japan's 253 percent government debt-to-GDP ratio as of 2017's accounting.

ROOM TO MANEUVER

The BOJ's balance sheet is now bigger than Japan's GDP and the JGB market is swamped by the BOJ's ownership, leaving little room for rapid balance sheet expansion. In short, the BOJ can't get much easier than it is now, but the Fed can -- and the dollar will pay the price.

Despite years of rising Treasury-JGB rate spreads, USD/JPY lost value each of the past three years and tumbled to its lowest since 2016 to start this year.
Over-reliance on the yen as a funding currency and heavy speculative yen short positioning has left USD/JPY vulnerable during global derisking phases such as we've seen since October.

This month's dive to 104.10 came as market expectations shifted from pricing more Fed rate hikes in 2019 to a possible rate cut, which would likely only happen if the economy were to slow dramatically or contract. Markets have since priced out a rate cut this year, but they still foresee 15bp of easing in 2020.

To be sure, a pause in Fed rate hikes or balance sheet reduction is not a foregone conclusion, though Chairman Powell and other policy makers have hinted that both are possible if conditions dictate.
Still, it is highly unlikely that the Fed will repeat the quarterly rate hike pace of 2018.

Assuming the U.S. economy simply slows rather than contracts this year and next as fiscal stimulus wanes, labor constraints and costs limit output and trim profits and the fallout from Brexit and trade deals proves manageable, the Fed would still probably be unlikely to do more than one more rate hike in 2019.

With the 2-10 year Treasury yield curve trading below 25bp since late November, there is a much greater risk of curve inversion with anything more than one more 25bp rate hike.

Another hike would put the Fed funds rate at 2.75 percent, slightly above current 10-year Treasury yields.
Historically it is several quarters between curve inversions and recessions, but the inversion itself is normally a clear beginning of the end of a tightening cycle.

In this case, the Fed tightening cycle has failed to provide Japanese policy makers with the higher USD/JPY their export-dependent economy needs.
In the absence of Fed tightening, or worse yet, an about-face to easing, the highly historically over-valued USD/JPY will be vulnerable to losing its triple-digit status, as it did during and after the global financial crisis until late 2013 and again after the 2016 Brexit vote.

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Source: efxdata.com

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