Japanese pickle, euro fickle: Sell EUR/JPY, sell EUR/USD
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From Deutsche Bank:
We expect EUR/USD to at least revisit 1.05 lows this year on the back of a very weak basic balance, a broadly stronger dollar and more scope for ECB balance sheet expansion, including the new TLTRO II auctions. Sell EUR/USD.
Medium-term EUR forces remain negative: The euro has been sidelined over the last few months but caution is warranted in extrapolating the range. One measure of FX market "trendiness" is the Vertical Horizontal Filter (VHF) which is currently at a record low for EUR/USD. It is exceptionally rare for such levels to persist for long and the risks are rising for an eventual break in the range (chart 1). We think the next break to the range will be on the downside as the medium-term drivers still point to euro weakness.
On the monetary policy side the risks are skewed towards more EUR/USD downside too. Although the ECB is unlikely to announce a new easing package over the summer months the upcoming new TLTRO auctions pose upside risks to the ECB balance sheet. Consensus expects a low net take-up in the TLTRO auction on June 24th compared to a maximum take-up of 1.9trio. The risks of greater balance sheet expansion stand in contrast to Fed pricing that is limited to at best one rate hike for this year.
The risks are skewed towards further JPY strength. There has been a structural shift in Japanese hedging behavior and BoP data suggests that domestics are still under-hedged for yen strength. Ability and willingness to shift inflation expectations higher is also declining. Sell EUR/JPY on diverging drivers, target 110
Japan drivers very positive for JPY. Yen drivers have experienced a dramatic shift and in contrast to the euro are now particularly positive. The most important change is in hedging behaviour where hedge ratios by Japanese investors are now rising. This not only reduces the impact of portfolio outflows as they are offset by yen hedge buying, but there is an outstanding stock of unhedged exposure that also needs to be adjusted. Accurate data on where we stand in this process is difficult to come by but the "financial derivative" balance from the balance of payments provides useful insight.
Relative monetary policy EUR/JPY negative. Beyond flows it is the collapse in Japanese inflation expectations and real rate differentials since the start of the year that have contributed to yen strength. Real rate spreads have captured the trend in EUR/JPY well and currently point to more downside (chart 5). The scope for impactful easing from the BoJ seems more limited than the ECB. With ownership of JGBs approaching 50% next year and the JGB curve exceptionally flat the marginal impact of a further increase in QE seems small, while the Japanese banking sector seems disproportionately vulnerable to further interest rate cuts given its unusually low loan to deposit ratios and the Q1 experience.
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