Macroscope: Long the yen against the euro

Since 2021, major economic cycles have been out of sync, presenting macro investors with opportunities to capitalise on policy divergence.

In August 2021, for instance, it became clear to us that US and Chinese policy was set to move in different directions. Chinese authorities had tightened policy notably in early 2021, while the Fed maintained exceptionally loose policy despite a booming economy. We proposed that tight policy in China would weaken the economy and force an easier stance from the People’s Bank of China in 2022, while the Fed would have to tighten aggressively to rein in a US nominal boom caused by excess stimulus in the years after the initial Covid shock. We believed that Europe would sit somewhere in the middle. With this macro view in hand, we built long positions in the US dollar versus Asian (Chinese yuan and Taiwan dollar) and European (euro and Swedish krona) currencies to exploit these dynamics. These positions were then closed in the summer of 2022 after this period of policy divergence became priced by markets.

Over the next 12-18 months we see policy convergence rather than divergence in the offing.

Our view is that policy is currently very “tight” in the US and Europe, becoming increasingly “loose” in China, and remains very “loose” in Japan. In our view, tight policy in the US and eurozone should result in growth and inflation continuing to moderate, causing the Federal Reserve (Fed) and European Central Bank (ECB) to move into easing cycles over the next 6-12 months. Increasingly loose policy in China is likely to be maintained to support a bumpy recovery, while the Bank of Japan (BoJ) will either do nothing or tighten modestly due to domestic inflationary pressures. So, while the past couple of years has been characterised by divergence (progressively tighter policy in the US and Europe vs. easier policy in China and Japan) it appears that we are now moving towards a period where these dynamics broadly begin to reverse.

In our opinion, the greatest asymmetry in positioning over the next 12-18 months is between Europe and Japan. Relative to what’s priced in, Europe will be compelled to ease and Japan to tighten.

In the second quarter of 2022 the ECB’s deposit rate was at -0.5%, while real GDP growth was running at c.4.5% p.a. and inflation was at c.8.5% - resulting in nominal GDP growth in double figures. Policy settings at this point were far too loose and inconsistent with prevailing fundamentals.

Currently, the ECB’s deposit rate is at 4%, while real GDP growth is c.0.1% p.a. and inflation a little over 2% p.a. Shorter-term measures, such as 3-month annualised, place inflation closer to zero at present. This is a radically different situation--on a nominal basis the economy is barely growing. In our view, there is a relativity high probability that the eurozone suffers a period of nominal growth contraction over the coming 6-12 months.

In Japan, the BoJ has maintained exceptionally loose policy in recent years. While the Fed and ECB have been raising interest rates and enacting quantitative tightening, the BoJ has been easing. This policy divergence has caused the yen to weaken against the US dollar and euro by c.25% and c.20% respectively since the end of 2021. The BoJ began a slow path of exiting from its yield curve control policy in late 2022 – slower than we had expected – and effectively removed that cap on bond yields in November. Inflation in Japan has been slower to get going but is now higher and likely to be stickier than in the US and the eurozone. Should this prove to be the case the BoJ could be set to continue the withdrawal of policy accommodation through exiting negative interest rates.

To summarise, we expect major central banks to ease policy and converge base rates down towards that in Japan, with the ECB’s policy settings being contrary to Europe’s weak fundamentals. As such we are expressing the prospect of policy convergence by being long the yen versus the euro in portfolios.