Watching the yen for fireworks

As it looks increasingly like markets have flipped the switch from inflation and growth concerns to recession, USDJPY has remained stubbornly high.

Recessionary warning lights are flashing everywhere. ‘Dr Copper’ lost a key support level and kept on dropping. Oil prices plunged by almost 10% on Tuesday, and the DBC commodity index posted one of its four worst days in the last sixteen years, falling by 6.6%. Interest rate futures are already pricing rate cuts by the Federal Reserve in the first half of 2023.

Eurozone inflation hitting 8.6% last week saw renewed demand for German 10 year bonds too. Inflation-adjusted yields are extremely negative,so it’s fair to speculate that investors sought safety for a downturn, rather than demanding higher yields in anticipation of a prolonged cycle of rate hikes.

On Monday, Germany posted a trade deficit for the first time in decades:

A brand new world or the result of Ukraine war disruptions in the German economy? Maybe a bit of both. Either way, there are plenty of challenges ahead for the eurozone economy and the ECB’s challenge of hiking rates into an expected slowdown.

Yet Japan stands strong…

Even as Japan’s ex chief economist Seisaku Kameda warns that “Inflation is going to clearly top 2% this year” and top the Bank of Japan’s expectations he cautioned that the central bank must be cautious with their messaging. Investors could see any changes as a signal that their monetary policy stance will change imminently.

For Japan, the current inflation is the ‘wrong’ kind. It’s coming from yen weakness and supply side factors. Here’s a snapshot of how the yen has fared so far in 2022.

Every major currency has gained vs Japan’s currency. The dollar is up over 18%! For years Japan has touted the benefits of a weaker yen, especially in a disinflationary world. The public might not agree in this environment. Japanese wages aren’t keeping pace with inflation. In May, inflation-adjusted real wages, (a measure of consumers' purchasing power), slumped 1.8% year on year.

Heading into upper-house elections, rising inflation is taking a toll on Prime Minister Kishida’s popularity. A July 4th NHK poll registered a 5% fall in approval rating from 59% to 54%. The polls were taken three weeks apart.

Kishida’s party is still expected to win a majority, but the poll highlights how inflation is becoming a political issue that the government may be forced to act upon if re-elected.

What could this mean for the yen?

A key driver of USDJPY is interest rate, or yield, differentials. Here’s a chart of USDJPY overlaid with two ‘spreads’ of those interest rates across the two year and five year maturities.

After Tuesday’s big risk off move, those yield differentials have narrowed, yet USDJPY hasn’t followed. It’s worth noting that correlations in markets break and ‘recouple’ frequently. But if this trend continues, those spreads could narrow and the yen could regain some appeal.

If recession fears continue to dominate and investors flock to bonds, that would drive yields lower. And if Japan hints at joining the hiking party, that could really add some fuel to the fire.

Not investment advice. Past performance does not guarantee or predict future performance.