FX Update: BoJ shocks JPY stronger with YCC tweak.

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Today's Market Quick Take from the Saxo Strategy Team

FX Trading focus: Step-wise move stronger in JPY on surprise BoJ policy tweak overnight. Interesting GBP weakness worth watching as full QT to resume early next year.

The Bank of Japan surprised with a 25 basis point hike to the 10-year JGB cap, even as Governor Kuroda tried to ease the impact of the move on markets in his post-meeting press conference with statements suggesting that this was “not a rate hike” and that it is too early to consider a general exit from or review of the YCC policy framework. The backdrop of a decelerating pace of tightening elsewhere and anticipation that the Fed policy rate will be lower than it is presently by Q1 of 2024 added to the strong reaction. As well, Kuroda’s stout defense of the policy framework at every turn had the market convinced that any shift in BoJ policy was unlikely during his tenure, which ends next April. The scale of the JPY reaction and it’s more than 12% rally off the lows against the US dollar, together with far lower commodity prices help ensure that we are very unlikely we are set for further policy tweaks under Governor Kuroda’s leadership, as these would aggravate JPY upside. This will likely mean that the ability of the JPY to continue higher after this step-wise reset will depend on the follow-up direction in global yields.

The market looks very complacent on Peak Fed next year and an eventual roll over to rate cuts by Q4. Push-back against further USDJPY downside is already here if incoming US data suggests a resilient US economy and/or more sustained inflationary pressures that keep US yields at current levels or higher, especially at the longer end of the US yield curve, the usual coincident indicator for USDJPY. If we look at the 10-year yield spread between USDJPY and Japan, it hit about 325 basis points for the first time in this cycle back in the mid-June time frame of the Fed’s first 75 basis point hike, when USDJPY was trading around 135 – so the current price already looks “fair” from that perspective. 130 in USDJPY probably requires an anticipated exit or at least further tweak of YCC from the Bank of Japan after April, together with signs that we are headed for a positive BoJ policy rate of perhaps +0.25% and for forward market expectations for the Fed and long US treasury yields to remain at current levels or head a bit lower. If US yields refuse to drop much from here, two-way market action may come in quickly for USDJPY.

While the JPY grabs all the headlines for now, it’s also worth considering the drivers of GBP weakness here as discussed in the GBPJPY chart below (should note that EURGBP has pushed on the range highs at times today, so this isn’t all about JPY strength).

Chart: GBPJPY
The JPY has risen as noted above on the surprise BoJ move to raise the cap on 10-year JGB yields, a move that is JPY supportive at first blush for obvious reasons (higher yields), but ironically requires that the BoJ conduct all manner of operations to purchase JGB’s to keep its yields in line with the YCC policy. The growth in the BoJ balance sheet has accelerated this year as the bank has conducted QE to keep yields under control, aggravating the JPY’s descent. This tweak of the YCC policy is clearly meant to off-load some of the pressure on the BoJ. Elsewhere, it is interesting to note that the Bank of England in recent days announced its intent to add long gilts to its quantitative tightening schedule from January 9. This is theoretically sterling supportive as it is a tightening of policy, but the UK is one of the most sensitive economies to any shortfall of demand for its sovereign paper, given the country’s yawning external deficits. That issue has become less urgent with the tight fiscal stance of the new government, but it’s worth watching sterling for signs of stress again if yields rise more aggressively at the longer end of the UK yield curve than elsewhere, which suggest a strain on trust in UK paper, and could mean that GBPJPY and UK-Japan yield curves could diverge meaningfully, if not as chaotically as during the moment of crisis during the Truss-Kwarteng “mini-budget” fiasco. Keep an eye on EURGBP as the key barometer for GBP after is jump above 0.8700 last week on the hawkish ECB. Stay tuned and note the interesting 158-160 zone in GBPJPY.