FxWirePro: Spot out divergence between JPY robustness and EM/high beta G10 FX softness

Growing risks of a trade war between the US and China continue to cast a cloud over global risk sentiment. Asian equity markets have continued to remain under pressure, although some indices have rebounded from their overnight lows.

The FX markets navigated two major events over the past week that left the broad dollar with no more directional clarity than before. The March FOMC under new Fed Chair Powell raised rates as widely anticipated and forecast an additional one-and-a-half rate hikes by the end of 2020, but any hawkish fallout for the dollar was contained by and the back-loaded nature of projected rate increases and only a marginal upward revision to the implied neutral real rate relative to the December’17 SEP.

Any designs of re-loading USD-funded carry trades on this relatively benign FOMC outcome, especially given the recent spate of soft-side US inflation prints that had allayed fears of a behind-the-curve Fed, were however frustrated by the announcement of US trade actions following the findings of the Section 301 China/IP investigation that hit equities harder than anticipated.

The 3%+ tumble in SPX after the release led to predictably sharp rallies in JPY and gold and declines in EM and high-beta G10 (refer above chart), and validated our trade protectionism template of decoupling between reserve and non-reserve FX that we have frequently cited.

The trades portfolio has run relatively light on risk in recent weeks, with a slight defensive lean predicated on navigating the uncertainty of potentially disruptive US trade policy. This has helped sidestep head-fakes in risk markets such as that following benign US CPI but has also missed participating in the extension of the yen rally after taking profits on AUDJPY shorts (in hindsight) too early around the VIX shock. Having been sidelined in the yen since then in anticipation of a seasonal uptick in unhedged Japanese outflows in the new fiscal year, we are cautious about chasing USDJPY lower from current levels, especially without the tailwind of broader dollar weakness.

Long reserve FX exposure is instead focused in two of the relative laggards – EUR and CHF – via longs in EUR/antipodean crosses and a short in USDCHF that eked out only workmanlike gains over the past week but offer potentially more durable returns on divergent monetary policy cycles even if trade tensions ebb.

The recent cooling in European dataflow is admittedly a risk to these trades, but one that still bears watching rather than acting upon in our view given the strong absolute level of activity. Courtesy: JPM

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