- U.S Treasury yields and the USD/JPY have recoupled.
- The "noise" created by the tapering is over.
- As a result, U.S. Treasuries and my macro-based models suggest a weaker yen.
The good old relationship between U.S. Treasuries and the USD/JPY is back in full force. As can be seen below, the disconnect registered in 2013 seems to be over. After several months of diverging trends, the USD/JPY is now moving in sync with U.S. Treasuries: higher U.S. Treasury prices => Lower USD/JPY.
Before answering the question of where this could lead us, it is important to understand the reasons for the disconnect - something that happened temporarily in 2011 as well.
Interestingly enough, the correlation break of 2011 can easily be explained by the rise in risk aversion (VIX), which was absolutely not the case in 2013.
Among the usual suspects, the tapering fear comes first as the FED turned more hawkish at a time when the BOJ was already implementing an aggressive quantitative easing. Given the ongoing normalization in U.S. monetary policy, and the lack of any reversal in the reduction of bond purchases by the Fed, I can base my USD/JPY forecasts on where the U.S. T-note price is heading.
This is all the more important since the new conundrum has brought the U.S. Treasury 10-year yield into a small range over the last few months (2.6%/2.8%) whose exit could lead yields either to 2.4% or 3.25%. The latter level is consistent with a rebound of the news flow index back to the tops registered over the last few years (Chart below - which is clearly my scenario).
This should support a bullish view for the USD/JPY.
To gauge the short run trend of the pair, we made a simple model of 13-week returns of the USD/JPY. It can be explained by:
1. Changes in the U.S. Treasury yields (+): higher U.S. Treasury yields lead to a stronger USD/JPY.
2. Relative changes in both Fed and BOJ balance sheets (+): relative quantitative easing matters as the most aggressive central banks manage to weaken their currencies.
3. The change of the spread between US and Japan 10-year inflation swaps (+): when the inflation spread between the US and Japan increases, the USD/JPY weakens.
The chart below shows that the 3-month return of the USD/JPY should stand above 0% - even when the lower bound of the model is taken into account.
This message would be confirmed by a fair value model, based on the same factors (+ VIX), estimated over the post Great Recession period, and which suggests that the USD/JPY may have moved too close to the lower bound.
Bottom Line: The downward of the USD/JPY trend should come to an end soon. Of course, there is always some potential for overshooting, but the recoupling of UST yields with USD/JPY as well as my macro-data-based models clearly confirms my bullish view on the pair for the next few months.