FX Update: CNH overheating? Fed taper message coming soon.

FX Trading focus: USD traders need to prepare for more taper talk

I was away from the office for the last two days of last week, luckily witnessing the transition to more summer-like temperatures in what has been an unseasonably cool May here in Denmark. My last update on Wednesday of last week had the subtitle: “USD is rather weak, but look at the backdrop!”, in which I argued that while the USD might be weak, the backdrop suggested that the support for USD bears has been turned up to 11, as the Fed’s excessive QE has created all manner of distortions, from record lows in Goldman Sachs’ financial conditions measure that we pointed out in this morning’s Saxo Market Call podcast to incredibly compressed credit spreads and spreads on mortgage securities to the ballooning Fed reverse repo facility.

On the very day of my comments last Wednesday, Fed Vice Chair Clarida was out teasing the need for eventual taper talk, the first recognition from the core of the Fed (as opposed to the odd regional Fed president) that the Fed can see that it is overdoing things. Clarida said “There will come a time in upcoming meetings, we’ll be at the point where we can begin to discuss scaling back the pace of asset purchases.”. Then on Friday we got the April US PCE inflation numbers that echoed the crazy spike in the CPI survey, as year-on-year core PCE inflation vaulted to the highest level since the early 1990’s and more impressively the month-on-month core number was the highest since the early 1980’s (save for a one-off odd spike recovery from a downward spike in Sep-Oct of 2001) at a rounded up 0.7%. Has this put the June 16 FOMC meeting in play for rolling out a more specific message on tapering? The most obvious starting point would be a timetable for eliminating the $40 billion in MBS purchases, which are not necessary when the market is at its hottest since the housing bubble, but let’s see. For now, it supports the greenback at the margin and may keep it from tumbling over the edge.

Chart: USDJPY
I have seen a number of other analysts bringing to my attention that this May was one of the least volatile calendar months ever for USDJPY, with a high of 110.20 and a low of 108.34, so a range of well under 2%. I didn’t even notice, given that USDJPY has been trading in a tight range since early 2017 and was unbearably boring for most of the last half of last year. But fundamentally, a significant real-yields gap has opened up between the US and Japan in the wake of this latest inflation data: one that favours the stable real-yields of the yen versus the now wildly negative yielding US dollar. The market is not picking up on this, but let’s keep an eye on status of the increasingly stale USDJPY rally after the strong move off the lows in March that peaked on the last day of Japan’s financial year on March 31. With last week’s rally to 110+, this area needs to hold to keep the focus higher, while a close back below perhaps 109.50-25 suggests we remain in range-trading limbo for now.