Morgan Stanley FX Pulse – Fed and BoJ Clear the Way
Sticking with USDJPY forecasts. We have been bullish on the JPY for the past year and are now looking for a bottom in this pair, expected between 97 and 100, before it heads back up to 107 in 2017. We think changing inflation expectations would drive a weaker JPY. There are three ways Japan could see higher inflation. First, domestically generated, via the success of Abenomics feeding through into economic data and stronger wages. Second, internationally generated, via higher commodity prices or an improved growth and trade outlook. Third would be an expansion of government spending, the measure that could speed up the rise of inflation expectations. If this spending is debt funded and causes a steeper yield curve together with higher inflation expectations, then this would cause the quickest JPY weakness and be the most bearish scenario. Our base case assumes a slow rise of USDJPY over the coming quarters.
Fed dots drive USD lower. The slower path for rate hikes and generally low market volatility should keep the USD weak vs the high yielding currencies such as AUD and NZD in G10 and IDR, BRL and RUB in EM. The Fed’s broad trade weighted USD index has failed to break above the July high, an important technical indicator, and we expect a further 4-5% decline from here. Our focus will remain on the high-yielding currencies but we also see some upside in EURUSD towards 1.17.
EM FX Trades. We stay bullish on EM currencies that offer attractive yield and improved fundamentals, including BRL, RUB and IDR. We also look to low yielders that have underperformed the rally and have attractive valuations. In this context we enter a short EUR/HUF position.
Long-term G10 valuations. We assess fair value across a range of measures for G10 currencies. These are all, of course, just indications and it can often take years before a currency returns towards its estimated fair value. We find that the USD is currently overvalued, particularly as productivity has declined in the US faster than in other countries and that GBPUSD is now trading 9% below its PPP estimate.
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Bottom line: The passing of the Fed and BoJ meetings has cleared the way for USD to weaken against EM and G10 commodity currencies. The Fed was dovish enough and puts the emphasis on upcoming data, which we expect to disappoint, and the BoJ ‘s new policy framework is unlikely to change the near-term JPY traj ectory (we expect USDJPY to fall below 100).We like buying AUD, NZD and NOK given improving data and (mostly) more hawkish central banks, as opposed to CAD which we sell given a more dovish BoC. We continue to see high carry EM currencies with strong fundamentals as the most attractive, particularly in an environment where the Fed will tighten only slowly.
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