In offering little suggestion of any impending shift in the strategy that it has employed hitherto, the Federal Reserve has conveyed a sense of resolution amidst a prevalence of lingering uncertainty over the outlook for US inflation and growth. The recent FOMC statement creates the clear impression that the Fed is no longer home to any great concern over the detrimental impact on consumer confidence (and hence economic growth) of hurricanes Katrina and Rita. And in view of the Committee’s awareness over the threat of rising inflation, this paves the way for the Fed to continue in its quest for the elusive ‘neutral rate’.
At this time, the futures market is fully factoring in a Fed funds rate of 4.75 per cent by the end of November next year. However, assuming that the FOMC moves rates on 13 December 2005, this suggests only a further two rate moves next year. This seems to be a surprisingly sanguine view given the warnings that senior Fed officials have given over the past month regarding the need to fight against inflationary expectations becoming embedded, the sharp rise in headline inflation and the risk of a spike higher in crude oil prices over the winter months (something that the technical charts suggest is a real possibility). We are reminded of Janet Yellen’s comment on 19 October that a range of 3.5 per cent to 5.5 per cent is “reasonable” for a neutral Fed funds rate and also remember that the last time headline inflation stood at current levels (in the summer of 2001) the funds rate stood at 5.75 per cent. Should interest rates remain the foreign exchange market’s modus operandi, then this should be supportive for the dollar.
With the yield gap between Japan and the US at the shorter end of the interest rate curve now standing at a far higher level than the pick-up available in yield from owning US Treasuries over JGBs, there is no value for Japanese investors in purchasing currency hedged US bonds. Indeed, it is very noticeable that the end of the dollar’s multi-year downtrend against the yen came at exactly the point that the one-year yield spread moved above the 10-year yield spread (at the start of December of last year). And the impact on the yen that this has had is made clear when we consider the following: the total average weekly capital outflows from Japan have exceeded equity inflows (we assume that foreigners have continued to purchase JGBs on an FX hedged basis) by a ratio of 3:2 so far this year - ¥329.6bn as opposed to ¥216.4bn. And foreign bond purchases have dominated these flows with an average ¥305.6bn weekly net purchases as opposed to ¥24.0bn for equities.
The yield seeking strategies of Japanese investors, the dominance of foreign bonds purchases in Japan’s capital flow data and the “measured” tightening in US monetary policy from June 2004 onwards have combined to deal a substantial blow to the yen. Since the start of the current fiscal year there has been a 90 per cent correlation between the performance of dollar/yen and the one-year differential between US and Japan; and this has risen to 98 per cent since the start of September as the pace of widening has accelerated. With the latest FOMC statement offering little suggestion of any let up in the Fed’s pursuit of a neutral stance, there seems little reason to believe that Japanese investors’ appetite for Treasuries is likely to subside any time soon. All in all, this would appear to point to further upside potential for dollar/yen.
Neil Mellor is a currency strategist at the Bank of New York.
Researched and published in association with The Bank of New York.
