The USD pared gains after speeding ahead in 1Q21 as the rest of the world catches up with the US in terms of vaccination rollout and on the back of a dovish Fed. USDJPY fell at the start of 2Q21 alongside the decline in 10y US Treasury yields, which continue to inform both the direction and extent of JPY moves.
USDJPY has moved in lockstep with US yields
Source: Bloomberg, Bank of Singapore
We see scope for the USD to weaken slightly in the coming weeks. But the road back to a weaker USD is not likely to be straightforward. There will be twists and turns. We recommend diversifying into JPY as a funder given the risks from two divergent scenarios with very different USD implications.
The weak USD scenario, which is currently playing out, involves a Fed that refuses to blink in the face of higher realised inflation. This results in rangebound nominal US yields, with higher inflation breakevens (the difference between the yield on conventional and inflation-indexed US Treasuries) offset by depressed real yields as shown in the subsequent chart. Remarkably, the 10y US Treasury yield, at 1.68%, is a mere 6bp higher than before the release of the very strong CPI print for April.
The Fed has plenty of excuses to remain patient about tapering for now, given the April nonfarm payroll disappointment. More broadly, the US has stopped beating growth expectations despite surprising on the upside on inflation recently. US growth momentum may be fading past the peak, but peak growth is not weak growth. A gradual deceleration perhaps, but US growth is likely to remain strong.
US inflation breakevens remain on a tear while real yields are depressed on a dovish Fed
Source: Bloomberg, Bank of Singapore
The strong USD scenario is where the market becomes concerned again of the Fed stepping up tapering plans in response to strength of the upcoming payrolls report and coming with significant revisions. Diminishing labour market slack could bring forward the point where the Fed's tolerance for rising inflation expectations may begin to wane. US real rates may rise, and this could bring the USD with it.
Japan's recovery this year is set to be the weakest amongst the major economies, lagging behind the sharp rebounds in China, the US, the UK and, increasingly, the Eurozone.
The Bank of Japan looks likely to remain in low interest-rate mode for much longer than its G10 peers against a backdrop of anemic inflation and muted growth prospects. This would constrain the ability of Japan’s 10y yields to keep pace with higher US yields in the medium-term. We target the 10y US Treasury yield and USDJPY at 1.9% and 110 respectively in a year’s time.
Japan is also one of the bigger commodity importers in the world while the US shale revolution has reduced the country’s reliance on commodity imports. The rally in commodity prices is a drag on Japan’s trade balance – another negative for the JPY.
