A potential oil production freeze to come out of the OPEC meeting at the weekend has pushed oil to its highest level this year. Higher oil has also pushed US corporate bond spreads tighter and equity markets and US bond yields higher. A stronger projected terms of trade for commodity-producing EM countries has put a bid beneath high yield, which does not seem surprising within a world of DM sovereign bond yields trading near historical lows.
Nonetheless, the latest risk-on move has left markets puzzled, as rising oil prices did not translate into rising inflation expectations. With oil prices rallying, USD weakening and the US output gap closing, US inflation expectations should rebound. Instead US real rates have moved higher. Seeing real rates rising when supported by real economic growth and productivity gains is healthy, but seeing real rates rising without productivity and income support is worrying, especially with respect to the long-term risk outlook. However, in the short term, higher US real rates should lend corrective support to USD/JPY.
USD/JPY is tightly correlated to real yield differentials. Stronger risk sentiment should weaken low-yielding currencies such as CHF and JPY on a tactical basis today. Stronger-than-expected China exports, rising 11.5% in USD terms, should also support risk. Today's US FX focus will be the release of March retail sales and the PPI. While strong readings here may not undermine current risk-on sentiment, they may weaken the support for low-yielding FX such as JPY and CHF.
The FT is reporting that foreign investments into Japan’s equity markets have declined by JPY 10.8trn from their June 2015 peak, with half of the decline seen since the start of the year. The underperformance of Japan’s equity market and the strength of JPY challenges ‘Abenomics’ on two fronts - first by reducing the domestic demand-supportive wealth effect and second by undermining medium-term inflation expectations, which for the highly indebted economy could additionally weaken activity.
A policy response seems warranted. The phrase ‘helicopter money’ is doing the rounds – a BoJ-funded fiscal expansion program. Increasing the amount of sovereign debt purchases via the BoJ without fiscal support would lead to even worse results in respect of its JPY-weakening impact. The BoJ buying ETFs in size has the potential to help ‘Abenomics’ via boosting wealth-related demand. However, rising JPY-denominated shares would see domestic and foreign accounts invest alongside the BoJ – which could in the long run even lead to a further rise in JPY. Tactically oriented traders may, with the help of rising real yield differentials and BoJ easing expectations, buy USD/JPY.
The risk-on, USD-weakening and EM-supportive environment seems to remain intact for now. To some extent we are reminded of summer/autumn 2012 when we projected a limited EUR/USD rebound to 1.30 in response to Draghi’s bumblebee ‘whatever it takes’ speech. While there is little doubt EM requires easier conditions, it seems that rising local asset prices and falling funding spreads do the heavy lifting, easing EM financial conditions for now. When this easing capacity has run its course, EM FX is likely to come under selling pressure again, which is not yet the case. Hence, USD should remain offered for now. 