USD JPY - FUNDAMENTAL ANALYSISThe US dollar (USD) has staged a comeback against the Pound Sterling (GBP) and Euro (EUR) over the past few weeks, but foreign exchange analysts at MUFG still consider that medium-term depreciation is the most likely outcome.
The bank considers that the US Dollar exchange rates are overvalued, especially against the Japanese Yen (JPY) and net capital flows are likely to be less supportive.
It also considers that the Euro-Zone and Chinese outlooks are more favourable, especially given that gas prices have declined sharply.
MUFG also expects the Fed will cut rates before the ECB while the Bank of Japan will tighten policy.
Monetary policy will inevitably be a key aspect. Although the immediate debate is still surrounding the potential for further interest rate hikes, MUFG expects the debate will switch to the potential for a Federal Reserve policy reversal as the US economy deteriorates.
According to the bank; “ The Fed will be cutting rates prior to the ECB. Inflation in Europe is stickier due to energy and food prices and the Fed will have much more scope to respond once economic conditions in the US weaken further from here. ”
After an extended period of quantitative easing, MUFG also expects that the ECB quantitative tightening programme through bond sales will put upward pressure on longer-term yields and support the Euro.
Global Growth Trends Still Favourable
MUFG notes that previous forecasts of an extended UK recession have been revised away and the Euro-Zone has also been resilient.
As far as China is concerned it adds; “ Recent data has disappointed, in particular on the manufacturing side of the economy, but pent-up domestic demand likely has further to run which will act as a source of global growth this year. ”
Although market sentiment has been more cautious, it expects overall growth dynamics will not favour the US dollar as Asia rebounds.
A related issue is the key area of energy prices.
The jump in energy costs last year was a key reason why agencies such as the IMF and central banks were so negative surrounding the European economic outlook last year.
Gas prices have, however, declined sharply with a slump from over 90% from the peak and close to 2-year lows.
Gas storage levels are also at very high levels in historic terms ang MUFG expects storage levels will hit 100% in the summer.
In this context, lower gas prices will improve the growth outlook and strengthen the trade outlook.
The Bank of Japan has resisted tightening monetary policy, but MUFG notes that the economy is strengthening and inflation has increased.
According to MUFG; “ we maintain that YCC has passed its sell-by-date and while it remains unclear whether price stability at 2% can be achieved, the BoJ will still move to widen the band or scrap it completely. ”
The bank expects that the yen will strengthen sharply if the Bank of Japan lets yields increase which will drag the dollar lower.
Negative Long-Term US Debt Dynamics
The immediate focus is on the US debt ceiling and political brinkmanship ahead of early June when the US Treasury will run out of cash.
These short-term dynamics are mixed for the US dollar with concerns over the economy, but potential defensive support if risk appetite deteriorates.
MUFG focusses on the underlying debt dynamics and the potentially unsustainable situation.
MUFG notes that the budget deficit in the first seven months of fiscal 2022/23 amounted to $928bn from $360bn the previous year.
On a longer-term view, in considers the debt dynamics will be potentially negative for the US currency.
De-Dollarization Hype
Although MUFG considers that the de-dollarization rhetoric is rather more hype than substance, there is still the risk that long-term confidence in the dollar will decline with scope for some further increase in Euro and yuan central bank reserve holdings.
MUFG also notes that there has been strong central bank gold buying and it expects this trend will continue.
The bank also sees a risk that the US use of financial sanctions will discourage official players to hold reserves in the dollar due to fears over asset freezes.
MUFG notes that there has been an extended period of Wall Street out-performance, but expects this trend will reverse and net capital flows will be less supportive for the US currency.
It adds; “ We see a renewed drop in US equities as investors position more assertively for US recession. ”
Japan’s Nikkei 225 index has posted a 32-year high and the German DAX index has hit a record high.
It also sees scope for a sustained rebound in emerging-market equities after an extended period of under-performance.
It adds; “ A reversal of the current period of deep EM undervaluation poses downside risks for the USD in the medium-term. ”
Long-Term Peak, Dollar Overvalued
MUFG notes that the dollar last year reached the highest level for over 20 years.
It also notes that at the October peak the currency index was 2 standard deviations stronger than the average over the past 40 years.
It adds; “ Similar extreme levels of USD overvaluation were last recorded in the early 2000’s and mid-1980’s and subsequently proved to be long-term bearish turning points for the USD. ”
The bank also considers that the dollar is substantially overvalued, especially against the yen, increasing the likelihood of mean reversion.
