Forex Institutional Research: Morgan Stanley FX Daily
Key quotes from the Morgan Stanley FX report:
We expect USD to be supported ahead of the Fed (Wed), RBNZ (Thurs) and BoJ (Thurs) meetings but the support should remain temporary. The Fed only introducing cosmetic changes to its previous statement may be seen by market participants as a sign of the Fed wanting to remain flexible, not yet taking the option off the table to hike rates in June if necessary. DM bond yields have been moving higher once again, which could be just the result of a portfolio shift as investors are developing a reflationary mindset, or higher yields could be the result of a shift in demand and supply of capital coming on the back of better economic activity. The problem is that recent data are not supportive of this view. Yesterday’s Ifo came in slightly weaker than expected and US housing market data showed sales falling behind construction activity suggesting higher inventories. This leaves higher bond yields being the result of diminishing cross border capital flows as the EM outlook improves. Anyhow, the steeper US yield curve has the potential to drag 2y yields higher, particularly relevant for FX, thus lending USD support. A Fed keeping the door open for a potential June hike will add USD demand in the short-term.
Playing USDJPY this week. The USD support may also extend to the JPY this week as markets expect further private sector asset purchases from the BoJ that support USDJPY towards the 112-114 region. We have explored the topic in more depth here: Video: What Can the BoJ Do?. Ultimately we believe it will be difficult for the BoJ to weaken the JPY due to capital flows and global risk appetite. Interestingly the GPIF’s president Norihiro Takahashi has today said they are looking to hedge USD and EUR based investments. Remember hedging would involve buying the JPY and the GPIF held 36% of their portfolio in foreign investments last year. We would use any USDJPY rally at the end of the week as selling opportunities.
Fed watching. This why the Fed has broadened its reaction function emphasising the importance of financial conditions. Correlations have increased globally as DM financial exposures to EM have increased from 2% measured in the mid-90s to 13% of DM GDP nowadays. Janet Yellen may pay homage to other more hawkish Fed members when formulating the Fed’s statement tomorrow, but when it comes to hike or not in the summer it will pay attention to global developments too. A weakening Asia triggering rising cross border flows and a higher USD may then delay the rate hike into December. Accordingly, a Fed statement leaving the door open for June may allow the USD to rally for a few days, but is not a game changer. For the USD to regain strength for good, local US conditions may have to become so strong that the Fed may have to retreat from its broadened reaction function. This is not the case yet.
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