Macro/FX Watch: Yen and yuan have more pain to overcome, Fed to hold

JPY: Underwhelming BOJ policy tweak could bring more yen weakness

There was a lot of speculation about a possible policy tweak going into the Bank of Japan meeting today. A Nikkei report from the night before said that the BOJ is set to consider a further adjustment to its YCC framework at Tuesday's monetary policy meeting, potentially allowing 10-year Japanese government bond yields to rise above 1%.

However, the BOJ underwhelmed yet again with only a marginal change to policy settings. The central bank added flexibility to its yield target, with the 1% target for 10-year yields now a “reference” rather than a strict target. The negative interest rate policy was left unchanged. The adjustment gives BOJ more optionality as market continues to test its limits. Had they simply raised the target to say 1.5%, yields would have likely quickly risen to test that as well and that would mean more BOJ purchases making the move costly.

The BOJ also raised its inflation outlook for FY 2023, 2024 and 2025 to 2.8% (from 2.5%), 2.8% (from 1.9%) and 1.7% (from 1.6%) respectively. Given that the central bank still expects inflation to return below the 2% target range by FY2025, it seems they still do not buy the idea that inflation could be sticky. That suggests that they will wait for wage negotiation results in early 2024 before any major policy tweaks.

USDJPY was disappointed with the subtle BOJ move and returned to 150+ from 148.81 lows after the Nikkei report raised speculation of a tweak earlier. The break of 150 last week proved that the level is not a line in the sand, and traders may be ready to push the limit on that. However, event risk from FOMC is also ahead in the week, so expect 152 to cap USDJPY for now. If Fed stays on higher-for-longer, USDJPY could be poised to touch 155 levels, however a dovish turn from the Fed could bring the pair down to back below 148. Medium-term, outlook for yen remains positive given the valuation discount, Fed shift to a dovish policy and a likely calibrated YCC removal, but traders may not be ready to bet on that yet given the huge yield differential and the carry advantage of the US dollar.

Market Takeaway: Dip buyers could continue to bring USDJPY higher to test 152 as BOJ underwhelmed expectations of a policy change. Fed risks ahead mean moves could be measured for now.

CNH: China’s PMI miss continues to raise doubts on the recovery

China’s official PMIs came in below expectations again, going against the recent signs of stabilization in the economy. Composite PMI dropped from 52.0 to only 50.7 in October with manufacturing dipping back into contraction at 49.5, down from 50.2 and an even bigger fall in the non-manufacturing index to 50.6 from 51.7. This could keep hopes of a recovery in China tentative. Focus is also on key policy meetings over the next few weeks, with National Financial Work Conference underway and that could be key for the financial sector. Authorities could attempt to find new ways to mend the fractured property market or create jobs for millions of unemployed youth.

USDCNH rose back above 7.33 and upside pressures could remain as recovery is still seen to be fragile. September highs of 7.3682 could be tested if hard data (GDP, retail sales, industrial production) also showed a deceleration or if stimulus measures coming out of this policy meeting underwhelmed. Any drop in USDCNH below 7.30 could continue to attract buyers.

Market Takeaway: China’s economic recovery remains fragile, and any drop in USDCNH to sub-7.30 could bring in buyers, but authorities seem to be wary of the 7.35 handle and may become aggressive with their fixings as pair moves towards that.

Fed preview: All reasons to stay on Hold

There is no lack of reasons for the Fed to stay on Hold at this week’s meeting.

1. US consumer is running out of its savings, and the “long and variable lags” of policy tightening could mean more economic headwinds are ahead.
2. The run higher in US long-end yields could do some of the work for the Fed and substitute for a rate hike as it tightens financial conditions.
3. Market may be reducing the geopolitical risk premium with Israel’s ground operation in Gaza remaining modest, but risks of an escalation still remain and Fed will likely not prefer to hike rates amid the geopolitical uncertainty.

In our view, the Fed is done, not just for this meeting, but for the cycle and the next move will be a rate cut. However, there is no dot plot at this week’s meeting, so it remains hard to gauge the thinking of Fed members about when the first rate cut could come. The post-FOMC press conference could be key here, and more push on the higher-for-longer message could still come as officials try to avoid the market un-doing the work it has done for the Fed. This could mean they could continue to leave the door open for further tightening if needed, and that will continue to make it difficult for market participants to move away from the long dollar positions.

Risk remains that Fed could potentially tilt dovish and market is prompted to bring forward the expectation of the first rate cut, and that could mean dollar longs could start to be liquidated. But for now, there remain few alternatives to the dollar, even as the upside may be limited here, given the dovish ECB, economic weakness in China and BOJ’s sustained dovishness.

Market Takeaway: USD retains the pole position going into the Fed meeting this week, and will be bolstered if higher-for-longer message is emphasized.