USD/JPY, EUR/USD: 'Fading Away'; Outlook & Trade Strategy - Credit Suisse

The essential principle that over time policy divergence will remain a driver of further US strength remains the key driver of our broader USD forecast set. In the specific case of USDJPY, the question now becomes why do we not forecast sustained gains beyond 125 over time on the back of last week's BoJ decision. After all, previous BoJ easing "surprises" since 2012 led to much more aggressive and sustained JPY weakness, with USDJPY typically pushing to new multi-year highs.

The key headwind now is that there are diminishing returns to scale to such moves when the novelty factor and perceived benefits of ever easier monetary policy are seen to be declining, and when global interest rates are all moving lower at the same time, even in countries like the US where the Fed only hiked as recently as December. 

This is not to say that we are not impressed by the implosion in JGB yields seen in the aftermath of Japan's introduction of negative rates. It's just that US yields are also moving sharply lower. As a result, rate differentials are not moving materially in favor of USD. There are also increasing concerns that USD strength may contribute to much slower US growth – or even a US recession – in 2016. This is quite different to the 2012-2014 period in which the USD was not considered sufficiently strong to pose a material risk to the US outlook.

As a result, not only has USDJPY failed to reach new cycle highs – it is now only back in the range it was trading at the end of 2015 – but the macro arguments for it pushing on to do so down the line are weaker than before. As for the US, the data flow continues to be unimpressive, with January's manufacturing ISM at a soft 48.2 and also the latest Fed Senior Loan Officer's Survey showing both tighter lending standards and weaker demand for credit.

Although the market is now pricing at most one more Fed hike in 2016, there is arguably still room for even this to be challenged near term. This is why we have delayed our forecast for renewed USD strength against the EUR and JPY to beyond the 3m horizon when hopefully some signs of economic resilience to global problems can emerge

We do not recommend jumping straight back into long USD trades against defensive G10 currencies such as EUR and JPY.

US Treasury 10-year yields closing in on 12-month lows support this thesis. Considering EURUSD more specifically, note it has now fully reversed weakness toward 1.08 seen in the aftermath of January's strong hints by ECB chief Draghi of more easing in March. This is despite German 5-year yields pushing lower to new record lows. Consistent with our argument above, we think EURUSD stability is in line with the fact that German rate differentials against the US are not moving materially given US 5-year yields are also being marked lower. If anything, the risk is that the ECB tries to push against market easing expectations being too aggressive. This suggests there is a near-term upside risk for EURUSD, after breaking above December highs above 1.1050. 

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