USD/JPY nears 145 – is risk building for a reversal around these highs?

Talk of the Fed having more work to do on inflation has so far thwarted market attempts to price in an abrupt end to the tightening cycle. But it’s time to fade those warnings. It’s likely the Fed is done in the absence of a re-acceleration in price pressures. That’s a low-probability play, even with the recent pop in energy prices, meaning the question is not whether the Fed will hike again but when it will begin to cut rates, and how quickly?

Right now, the inflation narrative continues to be dictated by changes in annual rates, rather than what happens from one month to the next. Assuming the trend doesn’t change, it means high base effect from strong monthly prints last year, coupled with softer readings for housing-related costs which make up a substantial weighting in both series, will see annual rates for both core CPI and PCE move rapidly towards the Fed’s target in the coming months. Good luck trying to convince markets about the need for further rate hikes under that scenario, no matter what your credentials. After 525 basis points, and with policy already in restrictive territory, additional tightening will only fan fears of the Fed overcooking things, risking a substantial undershoot on their inflation target and unnecessarily deep recession.

Fed funds still lean towards a Fed pause in September

While markets aren’t buying the warning from some FOMC officials that rates may need to move higher, attaching just an 11% risk of another 25-point increase when the Fed meets in September, they are rushing to buy the notion of “soft” or “no” economic landing. Fed funds futures expect the next easing cycle will be measured when it begins early next year, suggesting confidence the Fed will be able to deliver an outcome that results in little scarring for the economy or jobs market. But is that likely after such a rapid and significant increase in rates?

Monetary policy works with lags, often resulting in tightening cycles having to be reversed quickly when it becomes obvious that restrictive settings are no longer warranted. Often its up via the stairs for hikes, down via the elevators for cuts. That’s the risk again on this occasion.

Two-year Treasury notes – which are sensitive to shifts in sentiment towards the outlook for Fed policy –will be among the first instruments to adjust should confidence towards a soft or no economic landing begin to waver. That was seen earlier this year where several regional bank failures in the United States sparked concern over a potential credit crunch.

How will this impact USD/JPY and bond yields?

In FX, any adjustment in Fed expectations will influence USDJPY given the relationship it has with interest rate differentials between the United States and Japan. As the Fed increased rates aggressively over the past year, the Bank of Japan has maintained ultra-easy policy settings, including capping upside in 10-year Japanese government bond yields through its yield curve control program. Should interest rate differentials narrow, the USDJPY would normally decline, especially if accompanied by an increase in market volatility given the Yen’s safe-haven status. 

-- Written by David Scutt

Follow David on Twitter @scutty

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