USD continues to trade of softer footing heading into PCE deflator report

JPY: Initial BoJ sell-off has been almost fully reversed

The yen has continued to recover lost ground overnight following the heavy sell-off earlier in the week in response to the BoJ’s latest policy update. It has resulted in USD/JPY falling to an intra-day low of 142.81 which sits just above support from the 200-day moving average that comes in at around 142.70. The yen has now almost fully reversed the sell-off from Tuesday when USD/JPY hit an intra-day high of 144.96, and was trading at around 142.60 just before the BoJ’s policy announcement. The price action supports our view that a delayed BoJ exit from negative rates is unlikely to be sufficient in the current external environment to trigger another sustained sell-off for the yen at a time when there is intensifying speculation that other major central banks will begin to cut rates earlier and deeper next year. One of the main impacts of the BoJ’s cautious policy update this week has been that long-term yields in Japan have fallen sharply. The 10-year swap rate in Japan has fallen by almost 10bps to 0.8% since the start of the week while the 10-year swap rate in the US has fallen by around 5bps over the same period. It does though represent only a modest re-widening of yield spreads following on from  a sharp narrowing over the last couple of months.

The 10-year yield spread between US and Japan swap rates has still narrowed by around 92bps since 19^th October. Our short-term valuation model that takes into yield spreads, the price of oil and equity prices estimates that the fair value of USD/JPY over that period has fallen from around 153.00 to the current value of around 142.50. For USD/JPY to stage a more sustained rebound, market participants would have to more seriously question whether the Fed will deliver earlier and deeper rate cuts currently priced into next year. The next important text of that view will be provided by the release tomorrow of the latest US PCE deflator report for November. In light of the already released softer than expected PPI report for November, the report appears more likely to provide further evidence of slowing inflation that supports current market expectations for the Fed to move rates into less restrictive territory next year.   

The main news overnight from Japan has been a Bloomberg report stating that Japan is set to propose an initial budget for the fiscal year beginning in April totalling JPY112 trillion which would be similar to the record for the current fiscal year totalling JPY114.4 trillion. The government’s loose fiscal policy stance should continue to provide support for the economy, and contribute to a supportive domestic environment that we expect to finally give the BoJ confidence to begin raising rates in the 1H of next year. We had expected the BoJ to begin raising rates as early as in January, but there is higher risk now that could be delayed a little until April when the results of the latest annual wage negotiations in Japan will be known. An exit from negative rates in Japan is built into our forecasts for a stronger yen in 2024. 

SLOWING INFLATION CONTINUES TO DRIVE FX MARKET PERFORMANCE

Source: Bloomberg, Macrobond & MUFG GMR

GBP: Inflation back at BoE’s target in 1H of next year?

The pound has continued to trade at weaker levels after yesterday’s sharp sell-off triggered by the release of the latest UK CPI report for November. It has resulted in EUR/GBP rising back up to the 200-day moving average that comes in at around 0.8660 while cable has fallen back to levels recorded just after last week’s FOMC meeting between 1.2600 and 1.2650. The sharp pound sell-off was understandable in light of the scale of the downside inflation surprise in the UK. According to Bloomberg, it was the largest downside surprise for the annual rate of headline inflation since the release in March 2021, and the largest downside surprise for the annual rate of core inflation since the release in September. In the first hour after the release of the latest CPI report yesterday, EUR/GBP rose by +0.43% which was the largest equivalent reaction to a UK CPI report over the past year since the release in February.

The main reason why the latest UK CPI report has triggered a bigger pound sell-off is that it has challenged the view that the BoE will lag behind the other major central banks of the ECB and Fed when beginning to cut rates next year. It had previously been thought that persistent inflation risks were greater in the UK and would continue to make the BoE relatively more cautious over cutting rates. However, there is building evidence now that inflation in the UK is also coming down quickly like in the US and euro-zone with a lag. The annualized rate of core inflation in the UK over the last six months has slowed sharply to 2.4% in November down from a peak of 9.6% in July. While the data can more volatile on monthly basis in the UK, it is becoming harder for MPC members to dismiss the recent improvement in underlying measures of inflation. There was also further encouraging news yesterday when Cornwall Insight announced that they expect the Ofgem cap on domestic energy bills will fall by 14% in April of next year reflecting the drop in wholesale gas prices since mid-November. The favourable developments are reinforcing market expectations that headline inflation could fall back to the BoE’s 2.0% target in 1H of next year setting the stage for the BoE to begin cutting rates from Q2. While it is in line with our current forecasts for BoE policy (click here), the faster decline in inflation poses downside risks to our near-term pound forecasts.   

KEY RELEASES AND EVENTS

Country	GMT	Indicator/Event	Period	Consensus	Previous	Mkt Moving
UK	09:30	House Price Index (YoY)	--	0.0%	-0.1%	!
US	13:30	GDP (QoQ)	Q3	5.2%	2.1%	!!!
US	13:30	Initial Jobless Claims	--	214K	202K	!!!
CA	13:30	Retail Sales (MoM)	Oct	--	0.6%	!!
US	15:00	US Leading Index (MoM)	Nov	-0.4%	-0.8%	!!
EC	16:00	ECB's Lane Speaks	--	--	--	!!

Source: Bloomberg