Dovish BOJ Helps Dollar Recover

U.S. yields are stabilizing; Fed tightening expectations remain elevated; May IP will be the data highlight
The euro has recovered on reports that the ECB anti-crisis tool is starting to take shape; the fact that the ECB did not already have this tool in place when PEPP ended remains a concern; ECB tightening expectations remain elevated; BOE Chief Economist Pill identified some triggers that would require more forceful action
The BOJ kept all policy settings unchanged, as expected; stresses in he JGB market are rising

The Bank of Japan has helped the dollar recoup some of its recent losses. As we suspected, the dovish BOJ (see below) has helped trigger renewed yen losses and that has spread to the other foreign currencies. The weakening trend in the yen has resumed in force, with USD/JPY trading back near 135 and just shy of this week's new cycle high near 135.60. As risk-off impulses fade and BOJ dovishness persists, we believe the pair will eventually test the August 1998 high near 147.65. DXY is higher today after two straight down days and trading near 104.331. We believe it will eventually test the new high for this move near 105.65 from Tuesday once U.S. yields recover. The euro recovered on optimism regarding the planned anti-crisis tool from the ECB (see below). However, the bounce ran out of steam near $1.06 and we suspect markets will eventually be disappointed. As such, the May 13 low near $1.0350 remains in play. Sterling has gotten a reprieve as markets reward the BOE's more hawkish tone (see below). We are not convinced and we continue to target the March 2020 low near $1.1410. With the Fed maintaining a very hawkish stance, U.S. yields should continue rising, which in turn would underpin the dollar.

AMERICAS

U.S. yields are stabilizing. The 10-year yield is trading near 3.22%, up from yesterday's low near 3.18% but well below this week's peak near 3.50%. Elsewhere, the 2-year yield is trading near 3.15%, up from yesterday's low near 3.08% but well below this week's peak near 3.45%. While we acknowledge that this month's run up in yields was getting overdone in terms of the pace, we continue to believe that the direction remains intact. When all is said and done, we believe monetary policy divergences remain the dominant driver for FX. As the U.S. economic outlook remains the best relative to its DM peers, the dollar uptrend should remain intact.

Fed tightening expectations remain elevated. WIRP suggests a 75 bp hike at the next meeting July 27 is 75% priced in, while 50 bp hikes at the subsequent meetings September 21 and November 2 are fully priced in. Looking ahead, the swaps market is pricing in 300 bp of tightening over the next 12 months that would see the policy rate peak near 4.75%, up from 3.75% at the start of this week and 3.0% at the start of this month. Despite such aggressive pricing, the 2-year yield differentials with Japan, Germany, and the U.K. have all fallen this week from their peaks. Eventually, these differentials should move higher, particularly with Japan as the BOJ signaled no change in policy overnight (see below).

May IP will be the data highlight. It is expected at 0.4% m/m vs. 1.1% in April. June regional Fed manufacturing surveys have so far come in weak. Yesterday, the Philly Fed survey came in at -3.3 vs. 5.0 expected and 2.6 in May. This follows the Empire survey reported earlier this week, which came in at -1.2 vs. 2.3 expected and -11.6 in May. Despite the weak Fed surveys for May and so far in June, we believe that the manufacturing sector remains in solid shape. May leading index will also be reported and is expected at -0.4%m/m vs. -0.3% in April.

EUROPE/MIDDLE EAST/AFRICA

The euro has recovered on reports that the ECB anti-crisis tool is starting to take shape. ECB President Lagarde reportedly told eurozone finance ministers that the ECB's new tool will take effect when borrowing costs for the peripheral nations rise too far or too fast. She reportedly stressed that the new tool is intended to prevent irrational market movements that will lead to so-called fragmentation as the ECB embarks on its first rate hike in July. Lagarde she said the tool could be triggered if bond spreads widen beyond certain thresholds or if market movements exceed a certain amount, but did not specify whether those limits would be made public. Other reports suggest that bond-buying under any new mechanism would likely involve selling other securities in its portfolio. That is, ECB policymakers want to sterilize any interventions in debt markets so they don't add to upward price pressures. Countries that benefit from the new tool would have to meet certain conditions in order to avoid concerns that the ECB is financing eurozone governments outright. ECB officials want work on the new tool to conclude by the July 20-21 policy meeting.

The fact that the ECB did not already have this tool in place when PEPP ended remains a concern. Also concerning are the efforts to address the usual demands of the creditor nations to ensure that the debtor nations don't get any sort of free ride. When a neighbor's house is burning down, one should never nitpick about who's going to pay for saving them. At the same time, the issue moral hazard must be addressed; we understand that the creditor nations don't want the debtors to play with fire, knowing they will be rescued.

ECB tightening expectations remain elevated. WIRP suggests a 25 bp hike July 21 is fully priced in. Then, 50 bp hike are now priced in for the subsequent three meetings on September 8, October 27, and December 15 that would take the deposit rate to near 1.25% by year-end. Looking ahead, the swaps market is now pricing in 275 bp of tightening over the next 24 months that would see the deposit rate peak near 2.25% vs. 2.0% at the start of this week and 1.75% before last week's meeting.

Bank of England Chief Economist Pill identified some triggers that would require more forceful action. He warned that "if we do see greater evidence that the current high level of inflation is becoming embedded in pricing behavior by firms, in wage setting behavior by firms and workers, then that will be the trigger for this more aggressive action." Pill also cited rising inflation expectations as something else that could tip the BOE into more "aggressive" action. WIRP suggests a 50 bp hike move at the August 4 meeting is fully priced in, as well as for the subsequent meetings September 15 and November 3. Looking ahead, the swaps market is now pricing in 225 bp of tightening over the next 12 months that would see the policy rate peak near 3.50%, steady from the start of this week but up from 2.50% in late May.

ASIA

The Bank of Japan kept all policy settings unchanged, as expected. Governor Kuroda burnished his dovish credentials at his press conference, stressing that "It's pretty simple: Raising rates when Japan's economy is still on a path to recovery and GDP hasn't recovered its pre-pandemic levels would mean the economy would deteriorate further. It would risk triggering a big contraction." The policy statement made a rare reference to the yen, warning it will pay "due attention to developments in financial and foreign exchange markets and their impact on Japan's economic activity and prices." Yet as long as the BOJ remains ultra-dovish, the exchange rate will continue to weaken. Jawboning is all we are likely to see for now as any FX intervention would be going against the fundamentals and so likely doomed to failure. Updated macro forecasts won't be released until the next meeting July 20-21. The BOJ's commitment to YCC will continue to be tested ahead of that meeting. However, the YCC defense is leading to big dislocations in the JGB market. For instance, a shortage of cheapest to deliver 10-year notes caused by BOJ operations basically destroyed arbitrageurs in the so-called basis trade. These stresses are likely to intensify as the central bank and the market continue their battle over YCC.

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