FX review: The BOJ ties itself in knots, as the ECB leaves its next move up in the air

The best way to sum up this week’s market action is that central banks keep doing things. There were rate hikes from the Federal Reserve, the ECB and then the Bank of Japan joined the party early on Friday morning by implementing a surprise action –easing controls on its government bond market, which took the market by surprise and sent Japanese bond yields surging to their highest level in 9 years. The takeaway is that when central banks shock financial markets, things happen. The FX market was initially roiled by the surprise BOJ move, and USDJPY dropped more than 200 points, from above 140 to below 138.00. However, as the news has been digested, USDJPY has clawed back some gains and is now only 0.5% lower on the day. The yen is, finally, strengthening, but it is a slow process. USDJPY is down some 3.28% this month, and we expect this trend to continue in the medium term as a de-synchronisation process takes place in global monetary policy, with the Fed, ECB and BOE all nearing the peak of their policy cycle (bar a return of inflation), compared with the BOJ who could be on the cusp of tightening monetary policy.

The BOJ fiddles with monetary policy

Looking at the BOJ news in more detail, it announced that it would buy 10-year Japanese government bonds at a 1% yield, which is an unusual way to widen the trading band on 10-year yields. While this is the biggest policy change in eons, before we get too excited, it’s worth noting that the BOJ is still buying bonds, unlike nearly all other major central banks who are trying their hardest to sell government bonds and shrink their balance sheets. Interest rates were unchanged at -0.1%. Japan is the only country in the world with negative interest rates. The BOJ doesn’t seem to mind being outliers, they justified keeping interest rates in negative territory even though inflation is close to a 40-year high, by saying they need more time to ensure inflation remains sustainably at its 2% target rate.

The yen to continue its slow march higher

The BOJ has admitted that it wants to introduce greater flexibility to its yield curve control before it even thinks about normalising policy. The fact that it has resorted to a very complicated method of adding flexibility into its policy mix, suggests that the BOJ is not in the mind set to normalise policy a la Fed, BOE and ECB. However, the bond market believes that it is a move in that direction. We believe that the FX market is cannier than the bond market when it comes to the BOJ. The initial move lower in USD/JPY has been faded, which is a sign that FX traders believes it will be a long slog before the BOJ genuinely tightens monetary policy. Instead, Friday’s move to allow flexibility within its purchase of 10-year yields at the same time as keeping interest rates in negative territory should be neutral for the yen. As we mention above, USD/JPY is finally on a slow trend lower, we believe that this trend is led by the decline in US inflation rates, headline inflation in the US is now lower than headline inflation in Japan at 3% vs. 3.3% respectively. If this continues, regardless of this latest BOJ move, then USD/JPY should continue to decline in a relatively stable way, with Y135.00 the next major psychological target for year end.

What the BOJ has done is increase the chance of market-based volatility, which is likely to impact the FX and bond markets, as investors see Friday’s move as the end of yield curve control (YCC). However, this is not the end, but it could be the beginning of the end, which is a sign of how complicated it will be to end Japan’s decades-long policy of easy monetary policy.

The ECB ditches forward guidance

Elsewhere, the ECB hiked interest rates as expected on Thursday to 3.75%, the highest level since 2000, before the euro was in existence. However, in another “surprise” move, ECB President Lagarde ditched her practice of forward guidance, which leaves the ECB’s next rate decision in September up in the air. Her press conference leaned towards the dovish side when she said that the ECB does not have more ground to cover when it comes to hiking interest rates. This has sent the euro tumbling. EUR/USD was trading above $1.12 at the start of this week, and it is now below $1.10 at $1.0970 ish. This decline in the euro should have been expected by any self-respected FX trader. Of course, the ECB is close to its peak in hiking rates, interest rates in the euro area are at their highest level for 23 years, added to this, it was always likely that the ECB would peak around the same time as the Fed, even if they started hiking rates later. There is a fear around hiking rates too far in the Eurozone due to a hangover from the sovereign debt crisis. However, the ECB does need to be careful at this junction. Spanish inflation ticked higher in July on an annualised basis from 1.9% to 2.3%, although monthly figures showed a 0.1% decline. Thus, the market reaction to Thursday’s ECB meeting suggests that the bar to a hike in September is low, however, we imagine that the ECB will set policy based on what the data says, so an upside surprise to July inflation could see the ECB reverse track and consider a rate hike, which may cause the euro to rally once more.

The Fed sends long term yields surging

The Fed meeting this week was as expected, with a rate hike and no commitment of further increases in interest rates, which the market has interpreted as a sign that the Fed will cut rates soon. This expectation was reflected in the 30-year US Treasury yield, which surged nearly 25 basis points in the aftermath of Wednesday’s meeting. The lesson of the week is that when central banks are close to turning points, this is when volatility can occur. While the FX and bond markets are directly impacted by these decisions, the stock market is also indirectly impacted. Thus, investors need to watch central bank statements and policy meetings closely over the coming months.