FX Update: Three critical questions for the days and weeks ahead.

Three key questions for coming days and next week:

BoJ: are US yields are more important than BoJ hike and guidance?
The Bank of Japan is 95% priced to deliver a 25-basis point rate hike tonight, with the market pricing about 25 additional basis points of tightening. The rise in anticipation for this rate hike has failed to consistently support the JPY as global yields rose so viciously from early December, particularly (relative to prior action in the bond markets) in Europe. So, while the ECB remains on an easing path while the expectation for BoJ tightening, the pricing out of considerable ECB easing this year has the 2-year Eu-Jy yield spread far wider than it was at the December lows. I believe the ECB may end up cutting more than is currently priced (more like 150 basis points of easing versus just under 100 bps priced for this calendar year). And 2025 could prove more disinflationary than the market expects. Tactically, JPY can head in either direction, but looking for JPY to find sustained strength later this year.

But in the end, the long end of the US yield curve seems to dominate the outlook for the JPY, so capping USDJPY and seeing it significantly lower would likely require the US 10-year treasury benchmark to retreat well below the key 4.50% level as well as possibly some pain in risk appetite. The price action above 158.00 in USDJPY recently, by the way, looked a bit suspicious, particularly given volatility in US treasuries, from which I infer that Japan’s Ministry of Finance may have been intervening.

Tariffs are coming, is market too complacent?
We are all awaiting the shape of the Trump Tariffs, whether they will be broad or targeted (or both, for example, singling out specific product categories and countries for extra-high duties) and whether they will be ratcheted higher on a pre-determined schedule. The WSJ story published hours ahead of Trump’s inaugural address suggested we have some leeway while federal agencies investigate before the administration makes up its mind. That could theoretically take months, to be followed by additional months while the Trump administration negotiates with the targeted countries. This is basically the 2017 playbook, when it became clear that Trump would negotiate with China on a deal. The “Phase One” of that deal that was agreed in early 202 never saw China fulfilling its side of the bargain, a negligence it wrote off as due to the pandemic outbreak. It is highly unlikely Trump will have the patience for this version of history to repeat, given that only yielded modest results and plenty of avoidance via transshipments, etc.

A US president’s second term is all about building a legacy and every presidential term is about worrying about the inevitable tick-tock of the mid-terms in two years. So moving sooner rather than later will help start the legacy-building and then hopefully (from the administration’s point of view) getting to the other side of any market disruption from imposing tariffs, boosting the Republicans’ channels in the mid-terms. So, while we could see a wait of some weeks for the federal agencies to come up with a report, Trump’s team has likely already concocted its plans, and these may take the shape that is more characteristic of Trump’s style, especially this time around: to spell out the desired behavior change and to threaten with a tariff schedule that gets increasingly stiff if the target of the tariffs doesn’t comply. Could Trump move as soon as February 1 – quite possibly, yes, but move he will. He didn’t create the External Revenue Service for nothing.

Is risk sentiment more nervous than it looks on the surface?
On the surface, risk sentiment looks complacent – just yesterday we see stellar Netflix earnings and the announcement of “Stargate”, an AI-infrastructure investment binge from Softbank, Oracle and OpenAI pumping various stripes of AI stocks. But there are plenty of reasons to be nervous, the sharp comeback in stocks from the prior sell-off notwithstanding. First, there is the known unknown of the Trump tariffs as discussed above. But as well, there are market signs that nervousness is running high, the low VIX, for example, notwithstanding. One of those is the CBOE’s Skew Index, which measures the premium market participants are paying for deep out-of-the-money puts. That matched recent records yesterday. Clearly that is in part some insurance buying on fears of Trump tariffs, but it does suggest a nervous market. By the way, past markedly high skew readings didn’t correlate with weak 1-month market returns.

If we do get broad risk-off on tariff announcements, I would look for yields to drop and the USD and JPY to out-perform, while the Euro trades poorly, with CAD and MXN in a similar boat. Whether AUD joins in the weak column will be down to whether China allows the USDCNH “cap” of 7.375 to be challenged, something it has shown strong signs it has no interest in tolerating.

I will be back on Monday with a look at the week ahead, which features a heavier event-risk calendar, even if these events like the FOMC are a shadow of what they have been in the past, with Trump trumping all for now in this era of fiscal dominance.

Table: FX Board of G10 and CNH trend evolution and strength.
Note: the FX Board trend indicators are only on a relative scale and are volatility adjusted. Readings below an absolute value of 2 are fairly weak, while a reading above 3 is quite strong and above 6 very strong.

The FX Board showing how indecisive the market looks here as JPY has back-filled and chopped around, the US dollar has suffered a countertrend rally. Only sterling weakness sticks out in broad terms besides the overall gold strength.

Table: FX Board Trend Scoreboard for individual pairs.
In the individual pairs, we see some very icy realized volatility levels in the very low ATRs in many places, but note that EURUSD and GBPUSD ATRs are quite elevated (light orange shading) while JPY volatility has eased from much higher levels. The EURUSD positive trend reading is not really confirmed as noted above.