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USDJPY Reversal Would Signal a Shift in Focus from Rates to Risk

USDJPY Reversal Would Signal a Shift in Focus from Rates to Risk

John Kicklighter, Chief Strategist

S&P 500, Monetary Policy, Dollar, EURUSD and USDJPY Talking Points

  • The Trade Perspective: S&P 500 Bearish Below 4,000; AUDJPY Bearish Below 90; EURUSD Bullish Above 1.0650
  • An official ‘bear market’ for the S&P 500 would be more than just a technical designation – it would be a source of fear for those on the fence about the market’s medium-term
  • Sentiment is my topline concern moving forward, but monetary policy forecasts and growth are key catalysts; and USDJPY is at the crux of it all

Fear and Loathing Among the Bulls

The chop continues for the markets, but the threat of another sudden tumble in risk appetite continues to haunt those holding out for a miracle. That certainly is a biased view to suggest a bullish trend is far-fetched, but there is little in the way of genuine fundamental opportunity to point to when establishing where confidence can find a foothold. Inflation continues to push extremes in day-to-day measures like gas prices, food commodities and rent. The Fed and other central banks are unrelenting in their vow to fight price pressures – though we have priced a lot of this burden in with forward looking markets. Yet, it is the downgrade in growth forecasts where I believe we may find deeper retracement ahead. The run of policymakers that have committed to the fight against inflation with a stated tolerance for cooling the economy and perspective that markets are ‘orderly’ is a distinct warning that the central bank put which has been in place for over 13 years has expired. Should we add to that fundamental shift a distinct technical tipping point, it is likely that another wave of speculative holdouts will capitulate. For me, that threshold is the S&P 500’s dalliance with falling into a technical ‘bear market’. Crossing 3,830 would push a benchmark behind the most heavily traded derivatives, representing the largest economy and asset class in the world, over the edge.

Chart of S&P 500 with 1-Day Rate of Change (Daily)

USDJPY Reversal Would Signal a Shift in Focus from Rates to Risk

Chart Created on Tradingview Platform

I contend that headlines that flash the standard for US markets has officially crossed the Rubicon of prevailing trend will reach a category of market participant that holds steady through pullbacks. That is not to suggest they are HODLers of the reddit board variety but rather they are funds and institutionals with longer holding periods and larger positions. Retail and pure speculative traders move in and out at a much more rapid clip adding volatility to daily and weekly charts; but the deep-pockets tend to keep us on larger trends – whether bullish or bearish. Money managers who now have an asset/s that qualifies as in a bear market would be far more likely to rebalance and shift to defense. Meanwhile, the speculative crowd is holding out for a hero. We can see that in net speculative futures positioning measured in the CFTC’s Commitment of Traders report with a net long position of 121,775 contracts. Among the much smaller trader, retail CFD traders at IG are pushing their highest net long position on recent record.

Chart of S&P 500 and Retail CFD Positioning at IG (Daily)

USDJPY Reversal Would Signal a Shift in Focus from Rates to Risk

Chart Created on with Data from IG

What’s Driving the Market: Inflation, Growth, Interest Rates and Sentiment

As we transition into a new week of trading, there may be a modest jostling for influence; but I believe the same general drivers will continue to exert the level of influence we have seen pressure for months. As I described above, I believe sentiment is the end point for the larger trend in the overall market, but there are plenty of fundamental tributaries that will feed into that view. The level of inflation measured through energy and agricultural products can give us a daily pressure moving forward, but there is more weight but parsed out influence through matters of monetary policy and growth. Economic activity – or the outlook for it – is where the real leverage is in my view, and there is explicit event risk ahead to potentially catalyze the theme. The May PMIs for the developed economies are a timely and significant proxy for global GDP. A strong showing here can offer a sense of relief – though not likely a full blown source of recovery – while a slide would add unwanted fuel to the fire.

Chart of Google Search Trends for Key Trading Terminology

USDJPY Reversal Would Signal a Shift in Focus from Rates to Risk

Chart Created on

While economic activity has some of the most pointed event risk on tap over the coming week, the broader theme in monetary policy will continue to act as the fulcrum sentiment driven by fundamentals. We have digested UK and Canadian inflation statistics this past week with an unexpectedly inverted market response to significant increases in the measures. For inflation statistics over the coming week, only Friday’s US PCE deflator stands out to me. This is the Fed’s favorite price gauge and officials have made clear that fighting inflation is their principal objective going forward. Tempting the fates – as I have said this before – but it is likely difficult to push US rate forecasts much higher than the heights we have scaled this past month. Just this past session, the probability of a 75 bp move in July and for a fourth consecutive 50 bp hike through September has eased. That has put the Dollar at the beginning of a possible correction from its multi-decade highs. The loaded turn seems to be a feature of not just the Greenback, but also the Canadian Dollar, New Zealand Dollar, Euro and Pound (various under- and over-valued positions). If we are talking direct rate policy insight, there are rate decisions from South Korea and Turkey next week; but the RBNZ event is my top listing in this category.

Chart of CME’s FedWatch Forecast for September FOMC Rate Forecast

USDJPY Reversal Would Signal a Shift in Focus from Rates to Risk

Chart Created on CME FedWatch

Two of the Most Provocative Assets (Besides the S&P 500) - EURUSD and USDJPY

Drawing on the perspective of monetary policy, I find EURUSD a provocative opportunity itself; but it is also an important signal for the limitation of rate speculation. At some point, the hawkish outlook for the Fed will hit a zenith (relative to its major counterparts), and then there is likely to be some easing of its climb – so long as some other significant theme doesn’t pick up the baton. A series of four consecutive 50bp hikes through September and then a few 25bp moves thereafter would be very hawkish. As the expectations settle for this hawk, it would seem that pairing a Dollar fade against another serious hawk (BOC, BOE, RBA) makes sense, but those forecasts are largely saturated as well. Instead, I believe the still-dovish lean on the likes of the Euro makes EURUSD particularly provocative. As the pair rounds off a double bottom of a two-decade low, I’m watching for progress through 1.0635, then 1.0800 and so forth.

Chart of EURUSD with 20-Month SMA (Monthly)

USDJPY Reversal Would Signal a Shift in Focus from Rates to Risk

Chart Created on Tradingview Platform

When it comes to interest rate contrast, there is not more extreme a distinction for the Greenback than USDJPY. That said, there seems little scope for the Bank of Japan to begin closing the gap in the foreseeable future. Just this past week, Governor Kuroda made clear that he believes a strong program of asset purchases (QE) remains essential. If the perception of the Japanese monetary policy remains static, the US policy can be highlighted at the higher end. However, if we are looking at a full-scale reversal, I believe this will come through another means: full-blown risk aversion. It is worth pointing out that the US-Japan 2-year yield spread is a far stronger correlation (at least visually) to USDJPY, but the next phase of the pairs reversal likely rests with risk trends. And, it is my view that S&P 500 entering a bear market could materially escalate the deleveraging effort. This makes USDJPY a particularly well-placed macro gauge for what theme is most influential among the tectonic fundamental drivers.

Chart of USDJPY Overlaid with S&P 500 and US-Japan 2-Year Yields (Daily)

USDJPY Reversal Would Signal a Shift in Focus from Rates to Risk

Chart Created on Tradingview Platform

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.