FX Update: BoJ meeting looming large as US CPI focus fades.

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FX Trading focus: BoJ meeting next Wednesday looming large as US CPI focus fades

Yesterday’s December US CPI release and the subsequent market reaction suggests to me that the focus on the chief US inflation data points is likely set to ease on a month-to-month basis. The data was perfectly in-line with consensus expectations for a solid drop on the year-on-year headline and core to 6.5%/5.7%, respectively. And as we discussed on this morning’s Saxo Market Call podcast, it is no secret that the heaviest portion of the core inflation data point is the infamous Owners Equivalent Rent (OER), which has a 32% weighting and is notoriously lagging. Some private measures of rental inflation are already showing month-on-month declines and the year-on-year rises have approximately halved, while the OER data just posted a new high for the cycle in December.

This is not to say that inflation will no longer be in focus, but if it is to crop up as a significant concern again, it will more likely be on signs of aggravated rises in earnings, a reheating services sector, a new spike in energy prices, etc., all of which are in varying degrees of abeyance now. In other words, the incoming data still very important, but the focus will be far more diffuse. The upcoming earnings season, for example, will provide some interesting inputs as companies comment on Q4 trends and set their expectations for the coming quarter.

The strongest currency move yesterday was the rally in the Japanese yen, something that was set in motion ahead of the US CPI release by developments in Japan yesterday. Press reports that the Bank of Japan is set for further policy tweaks, a BoJ survey that upgraded the outlook for several regions in Japan and mentioned wage gains, and a preliminary report from the Ministry of Finance that December saw record selling of foreign bonds by Japanese life insurers were all in the mix. The benign US CPI data helped US treasury yields lower all along the curve, the Fed’s constant protestations notwithstanding, and JPY crosses headed sharply south late yesterday with the JPY posting new highs into the early European session today.

What will the Bank of Japan deliver? The market feels very uncertain but seems to be rushing to err on the side of caution, as 1-week implied volatility for USDJPY is at 21.5%, its highest since the pandemic outbreak and outright an extremely elevated level. This suggests that the Bank of Japan will have to deliver something, whether a hawkish hold or a surprisingly large adjustment to the band or something else to justify the excitement. There are no signs of directional panic in the risk reversals, but downside protection in USDJPY is naturally more expensive (3.3 handles more expensive for 1-week, 10-delta options).

Let’s recall that the December BoJ meeting surprised universally with the lift in the yield “band” – really a cap – to 0.50% from 0.25%. Bloomberg reports that only 1 analyst of the many surveyed is looking for any shift in the policy next week, but again, none expected anything in December either. I haven’t anything to add, other than it is ironic that the Bank of Japan is finally getting around to tightening with commodity prices massively lower and lower still on the strong JPY recover already in the bag, with US CPI data and long bond yields in full retreat and with expectations that a weakening economy will have the Fed cutting by later this year. Anything that opens a path for the Bank of Japan to leave negative rates and set itself on the path to, say, a 1.00% policy rate and an end to yield-curve-control needs a USDJPY reset of about 10-12% (at or below 115.00). For USDJPY to remain where it is or head back higher likely needs a USD liquidity crisis or a huge reheating of the inflation outlook that sees 2024 Fed rate cuts reversed and maybe even a higher terminal rate.

Chart: USDJPY
A fresh drop for USDJPY on US yields easing lower post-CPI yesterday and as the market braces itself for a possible further tweak to BoJ policy next week. Could wily Governor Kuroda deliver a nothingburger and leave further tweaks to his replacement in April or does he set up the expectation of another 25-basis point raise of the trading band and maybe a 10 bps hike to 0% at the March meeting, declaring that recent evidence of rising wages is vindication for his policy arc since 2013? For the policy rate, markets are only cautiously pricing an end to negative rates by April and a rate by end-2023 of +29 basis points. The frustrating setup here is that there is still a significant unknown of who will replace Kuroda in just a few months’ time. USDJPY levels include the 126.35 pivot low area (minor) and the bigger psychological level of 125.00 to the downside, while a reversal would need a quick back-up into 132.00 or so after next the Bank of Japan meeting, depending on where we are trading going into that event risk.