Two months have now passed since the Fed started to taper. During that time, the EM sell-off has taken the headlines, but perhaps more interesting has been USD/JPY. It has so far followed its historical pattern around the initiation of Fed hiking cycles since the 1980s (see first chart). That is, USD/JPY almost always weakens in the year after Fed hikes begin. Even the best USD/JPY reaction saw it only go sideways. Clearly, this does not augur well for our bullish USD/JPY view.
Delving deeper into the cause of this historical USD/JPY pattern, it would seem that growth, equity markets and bond yields do not exhibit a consistent pattern around the first Fed hike that could explain USD/JPY declines (they all tend to continue to rise). However, inflation expectations do pick up, US liquidity conditions worsen and Japanese investors tend to repatriate more. The first two could be repeated over the course of 2014 albeit likely at a much slower pace than the past. The biggest departure from the past could be in Japanese investor behavior. Abenomics seems set to encourage greater outflows from Japan. They are already evident in FDI flows, but have yet to show up in portfolio flows. Watching these flows will therefore be critical for yen bears.
Finally, FX correlations to US 2y yields have shot up to their highest levels since 2005 as markets gear up for a Fed exit from QE and ultra-low policy rates. The exception has been the core European currencies of EUR, CHF and GBP (see second chart). This makes sense as other currencies were the likely longs against the low-yielding dollar, so they should react most as US yields start to move. Eventually though the European “low-yielders” will start to get impacted by Fed policy either through them being used as the new funding currencies for “risk-on” trades or for US yields to offer enough of a premium to attract capital away from Europe (or both). We remain patient, awaiting such a rotation to occur.
Read the full report: FX Daily
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