Morning Commentary: Decoupling

Foreign Exchange - Morning Commentary
Decoupling  
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
One of the more striking FX trends in 2020 has been the yen’s decoupling from US-Japanese 10-year interest rate differentials.  Since the start of the year, this yield difference has steadily narrowed and is currently around a 3.5 year low.  Yet, the USDJPY exchange rate has remained relatively stable over the same timeframe.       

For context, the correlation between USDJPY and the 10-year yield spread was as high as ~0.94 just 6 months ago.  Currently, this correlation is now around 0.57.  A primary reason for this has been the uptick in investment outflows.  While a seasonal uptick after January 1 was expected, the magnitude of the increase is unusual.  Outflows at the start of 2020 have nearly doubled the equivalent time period last year.  On a weekly basis, there have only been two instances over the past decade that have exceeded weekly levels seen in 2020.  Both of these instances, in 2016 and 2018, happened in Q3, a time of year that is traditionally strong for overseas investment. 

Moreover, the share of unhedged outflows also appears to be rising.  Unhedged outflows amplifies the effect of these outflows.  Traditionally, banks fully hedge their foreign bond exposures.  This increase in unhedged flows represents the rising dominance of pension funds, insurance companies and retail investors. 

Persistently low interest rates in Japan have given domestic investors little choice but to mechanically invest funds overseas, giving these flows a structural nature that should be uncorrelated with market conditions.  This suggests that USDJPY appreciation will likely be limited absent a material change in market risk sentiment.  As a final note, Japanese equities are positively correlated to USDJPY due to the export nature of many Japanese corporates.  The currency pair’s resistance to the yield gap therefore also helps to explain why Japanese equities held up relatively well amid general weakness in Asian stocks. 
HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT:
  • Mexico’s central bank cut its key rate, in a unanimous decision, by 25 bps to 7.0% in line with expectations.  The meeting statement confirms that Banxico is in no rush to change its gradual approach to lower rates as the Mexican economy remains stuck between weak growth and rising inflation.      
  • German QoQ GDP continues to show the economy struggling to gain traction as it came in flat against expectations for a 0.1% gain.  Factoring in the COVID-19 disruption, the expectation is that the German economy will contract in Q1 2020.  Eurozone GDP also missed expectations, coming in at 0.9% YoY against expectations for a 1.0% increase.  EURUSD currently sits around its lowest level since early 2017.
  • US industrial production missed estimates, coming in at -0.3% against expectations for a -0.2% decline.  US retail sales for January did meet expectations at 0.3% but both the November and December numbers were revised down.   
  • The Fed announced that it will cut back on its repo operations again starting today.  This announcement builds on earlier actions that reduced liquidity injections last month.  The Fed's actions to increase bank reserves through bill purchases appears to have normalized funding markets.   There is probably not much read through here as the Fed will continue its bill purchase through Q2, making this just a technical adjustment. 
  • Japan’s parliament confirmed Seiji Adachi to replace outgoing BoJ board member Yutaka Harada.  Harada was seen as one of the more dovish members of the board but many are seeing Adachi as equally dovish.  Moreover, the two wrote a book together on how to spur inflation so their policy stances’ are very similar.  Adachi’s 5 year term will begin March 26.    
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