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Currency Point: The differentials

Currency Point: The differentials, FP Markets

 

Geopolitics and global inflation have been an interesting distraction from the fundamentals of FX. And there has been good reasons to follow these events as they have certainly played a major role in trade in the past 5 weeks. However, this distraction needs to be brought back into focus and fundamentals review. This means looking to the differentials in policy between pairs as even during this period fundamentals have still been core.

The best example of this is USD/JPY

USD/JPY – pure fundamentals

The Bank of Japan’s (BoJ) Governor Kuroda wants to cap 10-year Japanese Government Bonds (JGBs) 0.25 per cent. This is despite the recent spike in US and other global bond yields. To this end, the BoJ has made it clear that it is prepared to conduct unlimited quantitative easing (QE) to achieve this goal – compared with the US Federal Reserve that is laying the groundwork to shrink its balance sheet. The carry trade is strong with Japanese traders and this differential is hugely positive for USD/JPY and as real yields continue the profit of this carry only improves. Fundamentals are

EUR/USD – not so clear cut

The global inflation issue has come to the Eurozone in spades. Euro inflation is up to 6.7 per cent year-to-March, putting Christine Lagarde and Co under their first real bit of pressure on
policy. The need to hike the three main rates at the ECB has not existed for more than a decade in the zone and is an interesting change that lowers the EU-US policy differential. The ECB is moving on this possibility by ending QE – a precondition for any rate hikes. This has seen the 10-year bond yields rise and the cash/10-year curve steep. However, the Board is using communication to play down any move trying to stop any front- end pricing that could cause growth disruptions. The Board is fully aware of the downside risks to growth because inflation is a demand destructor. The board also has to think about the periphery as the end of QE means there could be funding problems for member states wanting to run larger fiscal deficits.

But – right now the larger problem is the longer the ECB holds off the bigger the rate differentials which is a EUR/USD negative, but a resolve of the Ukraine issue or a surprise from Frankfurt with a hike would knock the sentiment the other way.

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