Where is USDJPY Heading?

The US dollar has been facing downward pressure due to changing economic indicators and market expectations around US yields and monetary policy. A key currency pair, USD/JPY, recently showed significant volatility. During the US trading session, USD/JPY surged, rising two big figures from a low of 151.94 seen during London's morning trading on last Friday. This followed a sharp drop from a high on July 3rd, possibly due to intervention on July 11th.

The recent uptick was driven by a stronger-than-expected Q2 real GDP growth of 2.8%, surpassing the 2.0% consensus. Robust consumer spending, alongside higher government spending and capital expenditures, contributed to this growth. However, these data points reflect past conditions, not future trends. Current indicators suggest a slowdown in the US economy, which may lead to a more accommodative monetary policy stance.

Yield Curve Inversion

The yield curve, especially the 2-year and 10-year Treasury yields (2s10s), is a critical indicator of economic health and market expectations. The current inversion, which began in July 2022, is the longest in recent history and often signals a recession. While past inversions have sometimes led to a weakening dollar, there have been exceptions. For example, the brief inversion before the COVID-19 pandemic initially strengthened the dollar before it weakened. After the 2000 inversion, strong foreign direct investment (FDI) inflows kept the dollar robust.

Currently, the 2s10s inversion has narrowed to -15 basis points, the smallest negative spread since July 2022. This could indicate changing market dynamics, potentially influenced by stronger GDP growth. However, broader economic indicators like weakening labour markets, easing inflation, declining confidence, and housing market weakness could prompt the Federal Reserve to signal potential interest rate cuts soon.

USD/JPY and Market Correlations

The relationship between USD/JPY and other market indicators, such as the VIX (a volatility measure), is also important. Typically, when US front-end yields fall, the yen, seen as a safe-haven currency, tends to strengthen. Although higher US yields and inflation have recently diminished the yen's appeal, there's a potential resurgence of the yen's safe-haven status. The 10-day rolling correlation between USD/JPY and the VIX has turned negative again, suggesting that falling US yields may lead to a stronger yen against the dollar.

US Elections and Market Implications

As the US elections approach, political developments are becoming more significant. Vice President Kamala Harris has improved her net favourability rating, closing the gap with former President Donald Trump, though Trump still leads in key swing states. The financial market implications of the election are complex. Unlike the 2016 election, a Trump victory in 2024 might not provoke the same market reactions. This is partly because a Trump win wouldn't be as surprising as in 2016, potentially reducing market shock. Additionally, the Federal Reserve's current stance is different; in 2016, the Fed was tightening, while it may now be easing. The sequencing of Trump's policies, particularly around trade and tariffs, also remains uncertain.

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