USD/JPY Continues to Benefit from Solid U.S. Yields and Low Volatility

By USDR

The forex market appear to see little fear in the events that are currently unfolding around the globe.  Volatility generally rears its ugly head when issues such as the tensions that are growing in North Korea, or the Russian investigation into Donald Trump’s campaign are brewing.  Instead, volatility and fear are subdued, with the USD/JPY poised to break out to new highs and the VIX volatility index drifting to fresh all-time lows.

Central Banks are moving to Neutrality

There appear to be two drivers of the rise in the USD/JPY. The first is the lack of volatility and the second is the change in monetary policy from both North American and European central banks.  The Federal Reserve is well on its way toward normalizing its monetary policy.  Not only has the Fed raise interest rates twice in 2017, but in its last meeting minutes, officials discussed how to reduce the Feds balance sheet.

Recall, when the Fed was easing monetary policy in embarked upon a gigantic asset purchase program, where it purchased treasury securities as well as, mortgage backed securities.  The balance sheet grew as the Fed attempted to reduce rates below the zero-level, in an effort to spur on economic growth and asset price appreciation. Well, they were successful, as growth is moderate, job growth is robust, and the U.S. stock market is at all-time highs.

The process of normalization includes, increasing rates, and drawing down the balance sheet. The first way the Fed will handle this is to reduce the number of bonds it rolls over. Currently, when a bond matures that the Fed owns, the central banks invests the proceeds into another bond.  Going, forward, the Fed will let the bond mature and will not reinvest the proceeds. This will drain liquidity and in effect increase rates.  As the Fed continues to normalize and raise rates, stocks will eventually come under pressure.

The ECB, BoE, and BOC are moving to Neutrality

The European Central Banks along with the Bank of England and the Bank of Canada have also been hawkish.  In fact, in its last central bank meeting, 3 of the 8 governors of the Bank of England voted to increase their lending rate.  While the central bank appears to be hawkish, S&P recently stated that they don’t see a rate high until mid-2019.

The rating agency stated that Brexit-related uncertainties will continue to reduce economic growth. The agency forecasts UK growth at 1.4% for this year, and believes the BoE’s ultra-accommodative monetary policy will persist over the medium  term.

The ECB remains dovish, but a neutral stance is now in the cards.  Officials have been speaking out, but all eyes remains on Draghi and Praet.  These are the real decision makers and they remain in the dovish camp unwilling to break the recent economicmomentum.

The combination of subdued risk aversion and strong U.S. yields relative to Japanese yields, has lifted the USD/JPY above resistance seen near a downward sloping trend line that comes in near 113.50.  A break of the May highs at 1.1437, will lead to a test of the March highs near 115.  Support is seen near the 10-day moving average at 113.14.

All opinions expressed on USDR are those of the author and not necessarily those of US Daily Review.
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