G10 FX Weekly: Major G3 Pairs Face a Rangebound Month After Central Bank Flurry
- By Richard Jones
- 5 min read
Summary
- The US Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of Japan (BoJ) all tweaked their monetary policy last week.
- Price action in G3 FX markets was choppy and volatile as a result of these policy moves.
- As the dust settles this week, we take a short-term, month-ahead look at the major G3 pairs (EUR/USD, USD/JPY, EUR/JPY).
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Summary
- The US Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of Japan (BoJ) all tweaked their monetary policy last week.
- Price action in G3 FX markets was choppy and volatile as a result of these policy moves.
- As the dust settles this week, we take a short-term, month-ahead look at the major G3 pairs (EUR/USD, USD/JPY, EUR/JPY).
Market Implications
- Bullish EUR/USD – We remain bullish EUR/USD but would like to maintain only partial long exposure. We think the July range of 1.08/1.13 will hold in August and would like to buy dips into the bottom of the range should they materialise.
- Neutral USD/JPY – Whiplash price action in the Japanese yen last week left us less certain about JPY strength into H2 2023. USD/JPY has traded in a 137/145 range last month, and we think this will contain the pair this month.
- Neutral EUR/JPY – As with USD/JPY, volatile JPY price action last week makes us want to stay on the side-lines in this pair. The July range of 152/158 should hold through August, although the topside is (clearly) most vulnerable to a break.
Introduction
Last week saw the Fed, ECB, and BoJ announce new policy actions. The Fed raised its policy rate by 25bps on 26 July, as did the ECB the next day, followed by the BoJ tweaking its Yield Curve Control (YCC) policy to close the week.
These actions capped off an eventful July and led to choppy, volatile price action in the major G3 currency pairs – EUR/USD, USD/JPY, and EUR/JPY – at the end of last week and into this week.
As August begins, given the volatility mentioned above, we would consider cutting back position sizes during the next few weeks.
August is the height of the summer period in the northern hemisphere and, as such, liquidity will be at a premium and already volatile markets could be even more illiquid and choppy.
Additionally, each of the G3 central banks announce rate decisions next month, with the outcome of each being eagerly anticipated.
Ahead of these decisions, we expect the FX markets to churn around within the ranges established last month.
For the time being, we remain cautiously bullish EUR/USD, and neutral in both USD/JPY and EUR/JPY.
Fed, ECB, and BoJ Roundup
Although the Fed, ECB, and BoJ meetings last week moved the FX markets materially, each policy announcement left investors looking ahead to September with much uncertainty and expectation.
We now look at each central bank’s actions and communications in greater detail.
The Fed
The Fed raised its Federal Funds Target Rate (FFTR) by 25 basis points (bps) to 5.25%/5.50%.
This was broadly in line with market expectations heading into the announcement. On 25 July, the eve of the decision, the market priced ~97% probability of a 25bps hike.
As my Macro Hive colleague, Dominique Dwor-Frecaut, wrote in her review of the decision, the Fed announcement contained no surprises.
Fed Chair Jerome Powell said the data since the previous announcement in June had met the Fed’s expectations.
The Fed’s assessment of labour markets and inflation were both broadly unchanged from June.
Looking ahead, in the press conference, Powell’s remarks allowed the Fed to keep its options open for the upcoming meeting in September and beyond.
Powell, rather than providing any specific calendar guidance for the Fed, instead emphasised that the central bank would be data-dependent.
The market currently prices a very low probability (~16%) of a 25bps Fed rate hike on 20 September, and only a 34% probability of a rate hike at the following meeting in November.
The conclusion from this is that the market broadly believes that the Fed tightening cycle is now complete.
By the end of 2024, the market expects the Fed’s policy rate to be at ~4.15% versus the current 5.33%.
Dominique expects the Fed will hike again by 25bps in November, and further sees the market trimming back the probabilities of 2024 rate cuts currently priced.
The ECB
The ECB raised rates by 25bps on 27 July, taking the Deposit Rate up to 3.75%.
As with the Fed, this was broadly in line with market expectations heading into the announcement. On 26 July, the eve of the ECB rate announcement, the market priced a ~96% probability of a 25bps rate rise.
My colleague, Henry Occleston, wrote in his review of the decision that the ECB statement contained no surprises, describing it as ‘mundane.’
In the press conference that followed, ECB President Christine Lagarde spoke on many different issues, much of which Henry described as ‘noise.’
The key takeaway from the ECB’s messaging is that the central bank is data-dependent for September.
The market currently prices in ~6bps of tightening (a roughly 23% probability of a 25bps rate rise) on 14 September, with 14bps priced in total for the following meeting on 26 October.
The market, therefore, is far from fully convinced that the ECB will hike rates again.
Looking ahead to 2024, the market expects the ECB’s policy rate to be ~23bps lower this time next year than it is presently.
Henry’s view is that the ECB should hike at least once more, and not cut in 2024.
The BoJ
The BoJ rate decision was the most surprising of the three announcements last week, and triggered outsized volatility in JPY FX pairs (more on this below).
On the one hand, Japanese policymakers left the short-term policy interest rate unchanged at -0.1% on 28 July.
The BoJ tweaked its YCC approach, however, which was a source of whipsaw price action in JPY FX pairs.
The tweak was described in the BoJ’s statement as allowing the central bank ‘… to enhance the sustainability of monetary easing under the current framework by conducting yield curve control with greater flexibility…’.
In practice, this means that although the BoJ is sticking to its +/- 0.5% band around zero for the 10-year Japanese Government Bond (JGB) yield, it will now only use fixed rate operations at 1%.
Macro Hive CEO and Head of Research, Bilal Hafeez, described this as ‘a clever move,’ as this ‘half-adjustment should take a lot of pressure out of YCC ending-type trades.’
Moreover, given that the BoJ’s key inflation metrics are now forecasted at sub-2% by the central bank, Bilal saw this latest action as the BoJ ‘trying to exit YCC, but not signal any change in the policy rate.’
Twice this week, the BoJ conducted unscheduled bond buying operations to stem the increase in JGB yields, showing its commitment to the current stimulative monetary policy stance. Any move higher in JGB yields looks like it will be actively managed.
The 10-year JGB yield was trading near 0.5% before the announcement last week and is now trading just above ~0.6%.
In the short end of the Japanese interest rate curve, market pricing shows that the short-term policy interest rate is expected to be unchanged through year-end.
Market Outlook Post G3 Central Bank Flurry
We now look at the major G3 pairs – EUR/USD, USD/JPY, and EUR/JPY, in the wake of the policy announcements last week.
Bullish EUR/USD, But Keep Some Powder Dry
We have been bullish EUR/USD since February 2023.
Back then, the pair was trading near the bottom of a ~1.05/~1.10 range which had existed for the previous two-three months.
At that time, we advocated a buy-on-dips strategy, with a view to EUR/USD trading back to the top of that range.
We retained our bullish bias in the coming months, reiterating the view in April and in June.
This dip-buying strategy has been in place as EUR/USD has traded a series of new year-to-date (YTD) highs over the past five-six months.
The pair is currently (in what we see) as a downward correction from the YTD intraday high of 1.1276 seen on 18 July.
Back in February, our view was that EUR/USD could eventually trade near the ~1.13 level, which was last seen before the war in Ukraine commenced.
Looking forward, we think EUR/USD has room to trade back to the 1.13 level, so we still advocate buying dips.
For the next month or so, ahead of the G3 central bank rate decisions in September, we want to reduce position sizes to allow us room to add on any pullback to the ~1.0830 intraday low seen on 6 July.
USD/JPY to Be Contained by July Ranges
The Japanese yen is the worst performing G10 currency so far in 2023, with USD/JPY up about 9.5% YTD.
We wrote about the yen in May, arguing that the currency would reverse some of its losses in H2 2023.
Our reasoning was based on the view that tightening cycles ending elsewhere (notably in the US) would reverse the trend of JPY selling, and that haven demand for JPY would be likely to increase as the probability of recession was (and remains) elevated.
We reiterated a constructive JPY view two weeks ago, in a broader USD piece arguing that greenback weakness would feed into USD/JPY in the coming months.
The pair was then trading at ~140, and we highlighted the potential for a modest JPY rally in H2 2023, taking USD/JPY to ~135.
With the pair now trading on a 143 handle, we now want to maintain a neutral stance.
Our first instinct is to fade any move back to the recent top of the range at ~145. We lack conviction, however, and therefore prefer a watching brief in USD/JPY in the coming weeks.
EUR/JPY July Ranges Should Also Hold
Yen weakness in 2023 is even more visible against the euro, with EUR/JPY trading about 12% higher YTD.
Back in May, as part of our broader yen piece, we put forth a bearish EUR/JPY view. Since then, the pair has done nothing but rally. In the intervening period, EUR/JPY is ~7% higher.
The idea behind the stronger yen view was as outlined above – tightening cycles ending in most G10 currency jurisdictions (including the Eurozone) would reverse the trend of JPY selling, with yen demand increasing as a recession looked likely.
Now, after a volatile month for EUR/JPY, we take a neutral stance.
We think the ~152/158 range from July should probably hold, although a breakout through the top end of the range is (obviously) more likely, given the pair is trading near 157.
This is especially true if we are right about EUR/USD upside.
Having said that, in his note last week following the BoJ announcement, Bilal highlighted that on long-term, purchasing power parity (PPP) metrics, EUR/JPY is overvalued by 60%.
Although PPP is a very slow burn indicator, it is worth keeping in mind for the long-term.
In the coming weeks, however, we are neutral EUR/JPY.