However, while we acknowledge the risk of further near-term upside for the dollar, we believe the recent movement in USDJPY is set to reverse, and we expect the pair to reach 122 by year-end. We retain our least-preferred rating on the greenback and most-preferred view on the yen.
The minutes of the Federal Reserve's last policy meeting showed that the need for more rate hikes has become less certain. On the one hand, recent comments from Fed officials have been on the hawkish side, with governor Christopher Waller putting a “skip” (instead of a pause) on the table and leaning toward raising rates in July. Fed funds futures are now pricing in nearly a full 25-basis-point hike by July. But while the minutes for the FOMC meeting in May showed a wide dispersion of views from policymakers, they also reflected concerns over the economic effects of tightening credit conditions resulting from the recent banking turmoil.
According to the minutes, the Fed still has a recession in its baseline projection, with real GDP contracting in the final quarter of this year and the first quarter of next year. “Several participants noted that if the economy evolved along the lines of their current outlooks, then further policy firming after this meeting may not be necessary,” the minutes noted. Fed Chair Jerome Powell also appeared to be considering a pause, saying the US central bank has “come a long way in policy tightening” and that it “can afford to look at the data and the evolving outlook” to make assessments meeting by meeting.
The Bank of Japan looks set to normalize policy with positive economic data. Japan’s GDP expanded by 1.6% in the first three months of the year—quarter-over-quarter on an annualized basis—outpacing market estimates of 0.8%. Meanwhile, core-core consumer price inflation for April, which excludes fresh food and energy, accelerated to a 42-year high of 4.1%. The strength in the latest set of economic data should keep the Bank of Japan on track to adjust its yield-curve control regime sometime between July and October, in our view. We expect the central bank to raise the 10-year Japan government bond (JGB) yield target from 0.5% currently to at least 0.75%.
A deterioration in the functioning of the JGB market, due to high levels of official ownership, provides an additional incentive to shift away from ultra-easy monetary policy. The last BoJ survey showed further worsening of JGB market functioning, and the Japanese central bank remains keen to improve that. With the BoJ’s JGB holdings at around 52% of the market (as of end-2022), this problem provides another reason for the central bank to modify its current yield-curve control scheme. The next signpost for the central bank is a solid outcome from the Shunto wage negotiations, the traditional spring pay talks with trade unions. Talks so far have pointed to accelerating wage settlements, but the final outcome will only be known in early July.
So, we continue to recommend investors diversify their dollar cash or fixed income holdings, hedge outright, or position in options and structured strategies. In addition to holding long yen exposure, we see opportunities to sell downside in AUDUSD amid light positioning. We also see upside for the EUR, GBP and CHF against the dollar, and believe gold is an attractive portfolio diversifier and hedge.
Main contributors – Solita Marcelli, Mark Haefele, Thomas Flury, Daisy Tseng, Christopher Swann
Content is a product of the Chief Investment Office (CIO).
Original report - Yen weakness should reverse as dollar strength is unlikely to last, 26 May 2023.