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The EURJPY Rally Makes No Sense - Global Exchanges

FICC Podcasts March 22, 2022
FICC Podcasts March 22, 2022

 

In this episode, we discuss the surprising evolution of exchange rates over the past week, with particular focus on the strange concoction of influences that has led the EURJPY exchange rate to rise by 3%.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:

Hi, welcome to episode 37 of Global Exchanges, a podcast about foreign exchange markets and related issues. I'm Greg Anderson.

Greg Anderson:

For this week's episode, my co-host, Stephen Gallo and I, will discuss the surprising evolution of exchange rates over the past week, with particular focus on the strange concoction of influences that has led the euro/yen exchange rate to rise by 3%. The title of this episode is the Euro Yen Rally Makes No Sense.

Stephen Gallo:

Hi, I'm Stephen Gallo, a London-based FX strategist. Welcome to Global Exchanges, presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's co-host.

Stephen Gallo:

In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:

We strive to make this show as interactive as possible, so don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Stephen Gallo:

Okay, great. Let's mark the date. It's March 22nd, 2022, and cut right to the chase, given the title of this podcast. Despite the fact that Europe is having war on its own soil and having magnified upside inflation risks, magnified energy security risks, and downside growth risks relative to Japan, we've still seen the euro outperform the yen. And just looking at simple return metrics, spot euro/yen is up 3% since just before the war broke out. And it's up 2.6% last week alone.

Stephen Gallo:

Now, Greg, you've been covering the yen quite a bit in your recent notes and commentary. What do you think of the quirk?

Greg Anderson:

Indeed, yeah, I've been writing a fair bit about the yen this month, including in FX Weekly published yesterday. The reason's pretty simple. It's moving, and I've found over my long career as a strategy that I maximize readership if I write about the things that are moving.

Greg Anderson:

While I agree that the euro/yen rally is a, quote unquote, quirk, I do have to be fair to the situation and say that this is a yen move, not a euro move. Basically the yen is falling across the board against everything, while the euro is roughly holding still. That's where the yen is the source of the euro/yen rally.

Stephen Gallo:

Okay. I think where you're going with this, Greg, is to point out that euro/yen is mechanically following the yen depreciation, but it's not leading the move. I think in that case, can you talk a bit more about this move lower in the yen in terms of its fundamental drivers?

Greg Anderson:

Okay. Well, here's the laundry list of reasons for why the yen is weakening I think. Number one, Japan is almost completely reliant on foreign energy and the price has gone, up a lot. This presumably leaves Japan in a core flows deficit. Number two, the fed and most other central banks have been hiking and sending all kinds of hawkish signals, but the BOJ will not tighten, as Kuroda emphasized last week. Oh, and he also gave his view that the resulting yen weakness is a good thing.

Greg Anderson:

Number three, the yen did not perform very well as a safe haven asset as the Ukraine war launched. It didn't appreciate meaningfully. And with the negative [inaudible 00:03:55], it's basically an insurance policy. If an insurance policy doesn't pay off in a disaster, why keep paying the premiums?

Greg Anderson:

Lastly, number four, I'll just mention as an aside, there is a seasonality to the yen that tends to give it strength in the December to February period, and then weakness in the April to May period. And it seems like the market is figured this seasonality out. It maybe pushed it ahead by a couple of weeks into mid-March.

Stephen Gallo:

Now, Greg, I don't want to stray too far off topic with this one, but I'm intrigued to know why you think the BOJ has in a sense given the green light for further yen depreciation? In the short run surely this is only going to make the problem worse for Japan, right?

Greg Anderson:

It certainly makes the sticker shock of rising energy prices worse for Japanese consumers and producers. But look, Japan is still way behind the US and even Europe in terms of inflation. The February CPI reading was just plus 0.9% year-over-year for headline or total inflation, and still a negative 1.0% year-over-year for core CPI.

Greg Anderson:

Now Kuroda did admit that Japanese CPI is about to surge and could get above 2% year-over-year in the March data. That's because a big reduction in cell phone charges that happen in February of 2021 will roll out of the year-over-year frame. But look, Japan has had such a long-standing sub 2% inflation for so many years that for Kuroda, I don't think he can even fathom a world in which inflation might remain above target for a long time.

Stephen Gallo:

Greg, if we park that BOJ specific issue to one side and concentrate on the mechanics of the move in euro/yen, we're left asking ourselves, why is the yen the sole conduit for the FX market to price in policy diversions between the fed and other central banks?

Greg Anderson:

Stephen, if we go back to last two days, so day before the FOMC. Since that date we've seen US two-year yields rise about 35 basis points. But I wouldn't call that a widening policy divergence, at least not on many axis. I mean, the CAD denominated two-year swap rate is also up about 35 basis points. And Aussie denominated two-year rates are up about 30 basis points. Look, it seems that markets are just making the assumption that if the fed starts hiking more aggressively, that many other central banks will follow, just not the BOJ. A.

Greg Anderson:

Nd the other thing in the EM sphere, I would say that normally I would expect this kind of a surge in US interest rates would push risk sensitive EM pairs like dollar/MEX higher. But that hasn't been the case because the FX market has gone ahead and assumed that, well, if the fed starts hiking in fifties, Banxico is going to hike in fifties or do whatever to match the cadence of the fed.

Greg Anderson:

That leaves the yen very alone and isolated. Now, let me turn the tables and ask you. If the fed starts hiking in fifties, will the ECB? And if not, why isn't the FX market jumping on the short euro trade the same way that it seems to be jumping on the short yen trade.

Stephen Gallo:

Greg, I think the answer to your first question is that pretty much all the pieces of the puzzle for a demand or economic growth hit in Europe are there. And we can probably imagine that a key driver of that potential hit to growth will be uncomfortably high inflation for even longer.

Stephen Gallo:

No, from the perspective of central bank flexibility to focus on re-entering inflation expectations, the ECB, and probably the BOE, have less wiggle room for maneuver than the fed. That's assuming that the war drags on for a long while. So at this stage, I'm pretty confident that the ECB will not be moving at the same pace as the fed, under the scenarios where the war drags on well beyond the end of March. And many of the sanctions on Russia are permanent, even in the case of some type of prolonged ceasefire.

Stephen Gallo:

You could potentially make the case that a destabilizing move lowering the euro from an escalation of the conflict, might force the ECB to respond with tighter policy, just purely out of concern for the additive effects of euro weakness in the current environment. But as the war drags on, the case for emerging downside economic growth risks in Europe strengthens.

Stephen Gallo:

As for your second question, basically why aren't investors piling into the short euro/dollar trade now? I think this is mainly a function of the event risk uncertainty. We just don't know if we're going to get the news headline of a clear shift towards the war being over.

Greg Anderson:

If I could summarize what you're saying, you're saying that euro has headline risk that could make it pop two to 3% higher, while the yen doesn't have that. So that's why all of the carry trade shorting that we'd normally see in the basket of negative yielders, and by that I mean the yen, the euro, the Swiss franc, the Swedish krona, et cetera, all of that negative energy has been funneled into the yen in this particular episode.

Greg Anderson:

Hence we get a euro/yen rally that isn't based on expectations that Europe's economy will do better than Japan's, or really even that the ECB will hike more than the BOJ or anything like that. It's just about European currencies being sidelined from the shorting due to headline risk. What do you think then about euro/yen? What do we do with it here?

Stephen Gallo:

Greg, I'm 100% with you on the mechanics of the move higher in euro/yen. To emphasize, euro/yen is not leading the move lower in yen, it's merely following it.

Stephen Gallo:

The answer to your question is that I think you prepare to get short of euro/yen on the outlook for the medium term fundamentals. And by that I'm talking primarily about the more acute downside economic growth risks in Europe, if the war carries on. Or even if a large portion of the economic sanctions on Russia are permanent. And I have to stress that the longer that the war carries on for, the more likely those downside growth risks are to materialize.

Greg Anderson:

I agree with all of that. Euro/yen is a medium term sell for sure. I'd almost our argue that it's even a short-term sell at levels above 132. However, I guess that's a risky trade where euro/yen is still spiking higher, and might spike further on either a ceasefire headline or a war bad news headline that pushes oil back to its highs.

Greg Anderson:

There should be time and room to enter the short euro/yen trade after it's clear that the top of the spike has been put in. So maybe it's best to just stand aside for a bit longer.

Stephen Gallo:

Stand aside for now, but look for opportunities to get short on the view that the move higher in euro/yen doesn't make a lot of fundamentals sense. I think that pretty much sums it up.

Stephen Gallo:

We've probably worn out our welcome with listeners, so let's wrap up episode 37 here, Greg. And for our listeners who have stuck with us, thank you.

Greg Anderson:

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocm.com/globalexchanges.

Stephen Gallo:

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Incorporated, and BMO Capital Markets Corporation, together BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts.

Speaker 3:

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Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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