Waiting for a break

At Tricio we look at charts in order to help gauge investor behaviour and sentiment. The chart below is a very ‘old-school’ way of looking at bond yield spreads and foreign exchange markets. FX market drivers can be very simple, and also very complex. As a rule of thumb, higher yields will attract flow. The caveats around this are numerous of course. Real yields matter, as a high inflation, high nominal yield currency may have a relatively low real yield and traders may not back it.

In general though, the nominal bond yield spread on the chart below (red line) seems to lead the FX rate move at times, or at least work in the same direction. Except that this has clearly not been the case over the last year or so. The red line is falling hard (yield spread between the US 10-yr. note and 10-yr. JGB is narrowing) but USD/JPY remains relatively high. The argument could be that JGB real yields (nominal yield less inflation) are barely above zero while the US 10-yr. TIPS yield is near 1.75% - bolstering the USD. This is expected to change over the course of this year though as we expect the JGB yield to work higher towards 3%. This should see the red line fall further. And at some point, all else being equal, the blue line may fall hard as well if history is anything to go by.

Again, using bond yield spreads for FX trading (or hedging/currency overlay modelling etc.) is only one tool that is used by money managers and traders. It is easy enough to ignore in the short-term, but long-term views usually rotate back to yield spreads, which in this case, still argues for a lower USD/JPY. We agree with this direction, and are still looking for the JPY to work below the Y152/Y150 former resistance, now support area for another run at the key Y140 support zone. An eventual drop to Y125/Y120 remains favoured, with resistance/risk layered at the Y160/Y162 zone.

One factor to watch? Japanese pension and life insurance company flows over the coming year. They are traditionally seen as long-term bond holders. The narrative has been building that as JGB yields climb, there may be a push for them to reduce US holdings and buy more JGB's. This would take profits on USD positions (potentially) and leave them in their natural currency (which may be preferable at times). Early days of course, but see if this story builds over the coming year.

For further information on our research insights and our ‘Ask a Buddy’ CIO service please contact us at info@tricio-advisors.com 

Gerry Celaya

Chief Strategist