Searching for the Signal in FX

Many of the major Asian markets are closed for the Lunar New Year.  This week's G7/G20 meetings are drawing attention amid reports that officials may release a statement to address the fears of a currency war.  Even a formal statement is not forthcoming, we expect 1) such statements to come from the G7 rather than the G20 and 2) for the usual boilerplate commitment to fx prices best set in the market and that certain exchange rates are not the objective of monetary or fiscal policies. 

The reason that the statement is more likely to come from the G7 than the G20 is that there are too many countries in the G20 that do not really embrace floating exchange rates.  Japan is more isolated in the G7 than the G20 on that issue.  

Japanese officials appear to have changed tactics over the past week or so.  First, they are refraining from citing specific bilateral levels for the dollar-yen rate.  Second, as Fin Min Aso comments before the weekend illustrated, Japanese officials are response to the push back by others, and noted that the yen's recent decline may have been too rapid.  Third, Econ Min Amari opened a new front by talking about a 13,000 target for the Nikkei by the end of March.  This is an aggressive call as it would represent about a 3% rally a week. 

To put that in perspective consider the price action since Nov 15, when the election was formally announced.  The Nikkei has advanced nearly 30% through the middle of last week.  The dollar has appreciated by about 17.5% against the yen in the same time.  Assuming a similar gearing ratio, a 17% rise in the Nikkei could correspond to an 8% rally in the dollar toward JPY100.  Of course, this exercise is for demonstrative purposes.  The change in Japanese official rhetoric has not confused the underlying signal.  

The euro broke down to $1.3325 in exceptionally thin Asian activity, but managed to climb back to $1.3400 before running out of steam in the European morning.  There remains one key driver for the euro that helps explain both its earlier strength and its more recent heaviness. The signal is emanating from the interest rate market and in particular the two-year interest rate differential or swap rate between the US and Germany..  Nearly 8.5 days out of 10, euro and differential move in the anticipated direction.  When the US premium over Germany is reduced, dollar tends to fall.  When the US premium increases the dollar tends to rise. 

Drilling down into the respective components shows that the driver of the differential is the German side, not the US.  Recall what has happened.  In early December (10th), the Germany 2-year yield was near -9 bp.  It proceeded to increase to almost +32 bp by late Jan (28th).  It trended from there and was halved to almost 15 bp before the weekend.  We anticipate some near-term consolidation for the German 2-year yield, suggesting a choppy consolidative phase is likely. 

Sterling and the Australian dollar, which were out-performers before the weekend have come under strong pressure today.  Softness in the Australian home loan data was the local excuse, but interest rate expectations for next month's meeting seemed largely unchanged.  Nevertheless, the Aussie has returned toward Friday's lows, after staging a bit of an upside reversal.   A break of $1.0250 could see another cent decline before new attempts at bottom-picking emerges.  We note that the dollar-bloc as a whole continues to trade heavily. 

Sterling has already been sold through Friday's lows.  The proximate cause is a bit elusive.  Gilts are under some pressure, and there is some talk about the "flexible inflation target" that was discussed last week by Carney.  Initial support is now seen near $1.5680 and then $1.5630, the low form Feb 5.  There is keen interest against the euro.  The euro is staging a reversal against sterling.  Last Monday, the cross was trading near GBP0.8700 and finished last week near GBP0.8445.   It initial traded through there briefly and has not rallied through the pre-weekend high. This set up a potential key reversal.  The GBP0.8550 may offer initial resistance, but corrective gains could see the GBP0.8580-GBP0.8620 area.