GBP JPY - FUNDAMENTAL DRIVERS

GBP

FUNDAMENTAL BIAS: WEAK BEARISH

1. Monetary Policy

At their May meeting, the BoE delivered on expectations by raising the bank rate by 25bsp to 1.0%. There was an initial hawkish surprise as the vote split was 9-0 (no dissent from Cunliffe) and 3 of the 9 MPC members voted for a 50bsp move at the meeting. However, the hawkish reaction soon faded as it was also revealed that 2 of the 6 members who voted for a hike thought that this marked the end of the current hiking cycle. The dovishness didn’t stop there though as the BoE revised up their forecasts for peak inflation to >10% which added to the stagflation fears as the bank also saw possible GDP contraction in 2023. Furthermore, the bank took their first real stab at overly aggressive STIR pricing for the 2022 rate path by saying the current path would imply a big undershoot of their 2% inflation target in 2023 and was later backed up by Governor Bailey who said even though he thought rates should continue to rise he didn’t agree with those who think the MPC should be raising interest rates by a lot more. As the bank rate was raised to 1.0%, the markets expected some clarity from the bank on their plans to reduce the balance sheet . However, the bank decided to play for more time and said the bank will provide an update on their plans at the August meeting, pushing back expectations of active QT from Q2 to Q3. As a result of the overall dovish tone, Sterling fell to its lowest levels since 1Q21. The meeting confirmed market calls that the bank would look to hold rates steady after reaching 1.50%.

2. Economic & Health Developments

With inflation the main reason for the BoE’s recent rate hikes, there is a concern that the UK economy faces stagflation risk, as price pressures stay sticky while growth decelerates. That also means that current market expectations for rates continues to look too aggressive even after the BoE’s recent push back. This means downside risks for GBP if growth data push lower and/or the BoE continue to push their recent dovish tone.

3. Political Developments

Political uncertainty is usually GBP negative, so the PM’s future remains a risk. If distrust grows question remains on whether a no-confidence vote can happen (if so, short-term downside is likely), and whether he can survive the vote (a win should be GBP positive and a loss GBP negative). The Northern Ireland protocol remains a focus, with previous UK threats to trigger Article 16 and EU threats to terminate the Brexit deal if they do. Markets have rightly ignored this as posturing, but any actual escalation can see sharp GBP downside.

4. CFTC Analysis

Overall bearish signal as aggregate net-short positioning increased, pushing aggregate positioning (large specs, leveraged funds & asset managers) further below 1 standard dev from the 15-year mean. Even though the outlook for Sterling shifted to weak bearish from Neutral following the recent BoE meeting, we don’t want to chase the GBP lower from here. Not with both price action and positioning looking tactically stretched.

5. The Week Ahead

It’s a busy week for Sterling with the Monetary Policy hearings on Monday, Employment data on Tuesday, CPI on Wednesday and Retail Sales on Friday. The question markets want answered from all of these events are how bad the stagflation risks are getting. At the BoE meeting, the MPC forecasted a recession in the quarters ahead and also pushed back against STIR market expectations for the rate path, thus the tone for the hearings is expected to carry a similar dovish undertone. Between the data points, the CPI will be the most important with consensus expecting a more than 2% jump from prior on headline YY due to the 54% risk in household energy prices from the start of April. However, it’s important to realize that a lot of this has been priced in, and with the forecast distribution firmly skewed to the upside, it will arguably take something closer towards 9.5% on the headline or 7.0% on the core to really surprise and add even more stagflation angst. With inflation in mind, the main focus for the jobs print on Tuesday will be the wage components, to see whether further signs of second round effects are materializing. For Retail Sales, the question is how bad the cost-of-living squeeze has affected consumer spending. By the looks of it, consensus thinks quite a lot, with Core Retail Sales expected to contract by -8.4% from the prior of -0.6%. Just like inflation , it seems like the forecast distribution is firmly skewed lower, which means it would arguably take some seriously bad prints to surprise. Brexit will also be in focus, where recent threats of terminating the Brexit deal has been rightly seen as posturing, but if any side goes through with their recent threats that could open up a decent EURGBP buy opportunity.


JPY

FUNDAMENTAL BIAS: BEARISH

1. Monetary Policy

The BoJ kept all policy settings unchanged at their April meeting, which was in line with broad consensus expectations, but given the price action after the event did imply that a sizeable chunk of the market was expecting something more (us included). Due to the JPY weakness in recent weeks, markets wanted to see whether the bank would potentially increase their Yield Curve Control target band from 0.25%--0.25% to 0.50%--0.50%. But the bank decided to stick to their guns and maintain their ultra-easy policy despite the rapid depreciation of the JPY. The bank doubled down by saying they will conduct special open market operations on every working day as needed to keep the 10-year GBP capped at 0.25%. As expected, the bank reiterated their view that rates will stay low for the foreseeable future and won’t hesitate to add stimulus if the economy needs it. On the JPY, Gov Kuroda made familiar comments by saying they desire stable currency moves which reflect economic fundamentals. As a result of the bank’s inaction, all eyes will now be on the MoF to intervene if the rapid depreciation of the JPY continues.

2. Safe-haven status and overall risk outlook

As a safe-haven currency, the market's risk outlook is usually the primary driver. Economic data rarely proves market moving, and although monetary policy expectations can affect the JPY in the short-term, safe-haven flows are typically more dominant. Even though the market’s overall risk tone saw a huge recovery and risk-on frenzy from the middle of 2020 to the end of 2021, recent developments have increased risks. With central banks tightening policy into an economic slowdown, risk appetite has soured. Even though that doesn’t change our med-term bias for the JPY, it does mean we should expect more risk sentiment ebbs and flows this year, and the heightened volatility can create strong directional moves in the JPY, as long as yields play their part.

3. Low-yielding currency with inverse correlation to US10Y

As a low yielding currency, the JPY usually shares a strong inverse correlation to moves in US yield differentials. Like most correlations, the strength of the inverse correlation between the JPY and US10Y isn’t perfect and will ebb and flow depending on the market environment from both a risk and cycle point of view. With the Fed tilting more aggressive and targeting demand, we expect U10Y to push lower in weeks ahead (especially as inflation tops out). If that happens there could be mild upside risks for the JPY if US10Y corrects, but we shouldn’t look at that in isolation and also weigh it alongside risk sentiment and demand for the USD.

4. CFTC Analysis

Increase in Large Spec & Asset Manager net-shorts, but some reduction from Leveraged Fund net-shorts. With aggregate JPY positioning still close to 2 standard deviations away from a 15-year mean, the risk to reward to chase the currency lower from here is not very attractive. Last week saw some overdue correction in JPY pairs, but without a more substantial reason for US10Y to push lower the attractiveness to buy the JPY is limited.

5. The Week Ahead

For the week ahead, the focus will remain on the key drivers which is US10Y and more recently risk sentiment. Given the move in yield differentials and commodity prices, the JPY had very little safe haven appeal over recent weeks, but that was not the case in the past few weeks where we saw some classic safe haven demand for the JPY. This means, apart from the regular focus on US10Y, we’ll also be paying attention to any sharp moves in risk sentiment. Apart from that, eyes will also be on any jawboning from Japanese officials where the BoJ has placed the ball firmly in the MoF’s court to try and curb JPY depreciation. With the recent safe haven demand seeing some inflows into the JPY, that might give Japanese officials some solace and could mean more patience from their side regarding recent JPY weakness.