Yen carry trade returns, while Fed hawks squawk

  • Fed hawks squawk, but doves carry the tune
  • The return of the JPY funded carry trade?
  • What happens once the ECB bites the bullet?
  • RBA likely to remain on hold
  • Key data and events to watch in the week ahead

Fed hawks squawk, but doves carry the tune
A number of Fed speakers offered quite hawkish comments in speeches late in the past week. Minneapolis Fed’s Kocherlakota, Phila.’s Plosser, KC’s Hoenig, Dallas ’s Fisher, and Richmond ’s Lacker all suggested the economy was strong enough, and inflation threatening enough, that extraordinary accommodation should be removed. Kocherlakota went so far as to suggest rates should be ¾% higher. Importantly, only Kocherlakota and Plosser are 2011 FOMC voting members, and even more importantly, they’re all known hawks, so such comments deserve to be discounted, especially with unemployment still at 8.8% (and U6 underemployment at 15.7%). NY Fed pres. Dudley countered with a distinctly cautious view of the recovery and indicated in no uncertain terms QE would be completed on schedule and that it’s too soon to consider tightening measures. The NY Fed president is the second among equals on the FOMC as vice chairman (the chairman is first, of course), and his comments reversed earlier market moves based on the hawks and better (but far from great) US employment data. US Treasury yields turned negative and may be signaling a near-term peak. The USD reversed its post-NFP rally, and is also showing signs of having topped out.

While we expect future Fed comments to develop along similar lines, we think the Fed will ultimately remain on hold for quite some time, likely into 2012, after wrapping up QE2 on schedule. This is likely to keep the USD biased to the downside in the meantime and makes us cautious about further gains in USD/JPY (see below). However, this is not to say that JPY-crosses may not see further gains. Instead of rallying further on a higher USD/JPY, they could see higher on a steady USD/JPY and higher EUR, AUD, CAD, and NZD against the USD. Which brings us back to the question of why is risk rallying so strongly in a still highly uncertain environment? In fact, key risk markets like stocks have only returned to prior highs, so JPY-crosses stand out as a potential overshoot at this point, rather than a leading indicator. Below we suggest JPY-cross strength is mostly due to positioning, which also makes us cautious on further gains. Still, we will look to use remaining USD strength against all but the JPY as a selling opportunity while the following support levels hold on a daily closing basis: EUR/USD 1.4000; AUD/USD 1.0150; USD/CAD (resistance) 0.9850; NZD/USD 0.7550. Fed chairman Bernanke speaks on financial stability on Monday evening ET, but there will Q&A and we’re sure he’ll get a chance to weigh in on the outlook.

The return of the JPY funded carry trade?
USD/JPY and related crosses have surged out of the gates since the historic coordinated G7 intervention on March 18th. Expectations for widening interest rate spreads as a direct result of easy BoJ policy for the foreseeable future has set the ‘JPY funded carry trade’ on its proverbial course – USD/JPY has gained 8 big figures, EUR/JPY is fast approaching the 120.00 figure, GBP/JPY recovered 13 big figures, and AUD/JPY is nearing 2008 levels around 90.00 in just a matter of weeks. JPY has been ripped away from the normal currency landscape as market participants have become exuberant on prospects for higher yields and accelerating growth – possibly even over-exuberant.

While many have attributed the move higher in yen pairs as a reflection of shifting fundamentals, we are cautious to make such an assumption. Instead, we think position adjustments may have been the main driver to post-intervention yen weakness. The sharp JPY decline is likely to have caught Japanese exporters over-hedged and scrambling for the exits, even reversing long JPY hedges to the short side. As part of its intervention efforts, the BOJ ‘requested’ that exporters needing to buy JPY should transact directly with the BOJ. This also removes a significant source of JPY buying from the spot market, effectively lifting the lid off USD/JPY and JPY-crosses. Additionally, model types no longer remain on the offer and have likely switched to the long side, exacerbating recent JPY declines. Finally, 4Q data from the IMF suggest international reserve managers increased their JPY buying during the period, and we can reasonably presume they were still active JPY buyers for much of the 1Q given persistent JPY strength. After the G7 opted for intervention, however, that JPY accumulation is likely on hold and may even be reversing. As with any major position adjustment, it’s next to impossible to know in real time when it has run its course.

There is a lesson that can be learned from the 2008 financial crisis - the ‘carry trade’ can unravel at a much faster rate than it develops. Accordingly, we think caution should be heeded on the recent wave of ‘JPY funded’ carry trade optimism especially as many JPY pairs trade near significant levels. USD/JPY ran into a brick wall into the 84.50/75 level, a key horizontal pivot on a daily basis, and faces additional resistance directly above into its declining primary trendline around 85.75 (extended from the 2007 peaks). 120.00 is likely to be a key technical and psychological barrier in EUR/JPY as is 90.00 in AUD/JPY. Strength above these levels would suggest further gains ahead, but overall we believe it may be too early to call a complete reversal in the JPY’s underlying trend.

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