A closer look at USD/JPY and what to expect for the remainder of the year
USD/JPY closed around 108.61 in December 2019 after the U.S.-China trade deal 1.0 (under Trump) before making a high around 111.72 in March 2020 amid a USD shortage in the money market (as a funding currency) after the breakout of COVID-19 and plunge in risk assets. Then the Fed launched an unprecedented QE-4 and cut rates to near 0%. Subsequently, USD/JPY slumped to a low of around 102.88 in December 2020 and closed the year around 103.24. Further along in 2021, USD/JPY got a boost amid rapid progress of herd immunity ostensibly brought on by COVID vaccinations in the U.S. and the gradual reopening of the economy and society. As a result, USD/JPY made a high around 111.67 in July 2021 amid expectations of QE tapering from December 2021, earlier than the expected date of December 2022.
Currently, USD/JPY is trading around 109.20 (2nd August):
USD/JPY is under pressure on plunging U.S. bond yields amid the Fed's daily reverse repo (RRP) to the tune of almost $900B on average to suck out excess liquidity from the banking system. Banks are buying USTs from the Fed in the secondary market with their excess cash liquidity, resulting in higher demand for USTs. Thus, prices of USTs are getting higher as bond yields are going lower, dragging USD/JPY along.
For the last few months, the lack of adequate UST (US debts) supplies in the primary market made banking liquidity higher, and thus banks are temporarily deploying excess liquidity with the Fed through buying USTs from the secondary market to earn a decent risk-free return. The Fed is the biggest holder of USTs and is now actually doing backdoor QE tapering to suck excess banking liquidity to tame inflation (indirect financial tightening) and U.S. borrowing costs (bond yields) are lower.
What's next for USD/JPY in the rest of 2021?
The Fed's dual mandate is maximum employment (inclusive and broad-based) and price stability (average core PCE inflation around 2% for a period of, say, 2018-23). The Fed will first go for QE tapering if it sees 'substantial further progress' of its dual mandate from December 2020 levels. The Fed does not define nor quantify 'substantial further progress' to keep goalposts/options open. In its last policy meeting (29th July), Fed Chair Powell acknowledged that although U.S. inflation (core PCE) is now around +3.5%, substantially above the Fed's 2% target, it's only half of the Fed's dual mandate as the employment situation is still far from the Fed's definition of 'maximum inclusive and broad based' goal (from December 2020 levels).
Also, the Fed sees elevated inflation as transitory due to supply chain disruptions (bottlenecks); i.e. lower supplies against higher pent-up demand as the economy is reopening and consumers are flushed with funds/savings, thanks to an unprecedented monetary as well as fiscal stimulus (CARES Acts, extended PUA, etc). Powell and the Fed also point out that surging inflation is not widespread, but confined to limited products and services linked to the reopening of the economy like used cars (automobile chip shortages, lower production of new cars), house building material (lumber), and airplane tickets; i.e. supply is less than demand. The Fed thinks that supply will gradually pick up and demand will fade after 2021, leading to equilibrium and y/y inflation will gradually move back to around +2.0% by 2022-23.
In the Fed's latest economic projections (dot-plots), they have projected 12-month core PCE inflation (y/y) +3.0% for 2021, +2.1% for 2022-23; i.e. an average inflation around +2.4% over 2021-23 (three years). Now, although the Fed has not specifically defined the lookback period for its average inflation targeting mechanism, assuming the 2018-20 period (three years), the average core PCE inflation was around +1.6%. Thus if the Fed can keep average core PCE inflation for the 2021-23 period around +2.4% as per its projections, then average core PCE inflation for 2018-23 (6-years) could be around +2.0%, at the Fed's price stability goal (average inflation targeting at +2.0%).
On the maximum employment front, the Fed will not only look into headline unemployment numbers but also pre-COVID labor force participation numbers, wage growth, and employment across the spectrum. The Fed will count the pre-COVID labor force which was around 1645K in February 2020 against the June 2021 figure of 1611K. If we take into account 1516K employed Americans as per the latest June 2021 NFP data (BLS), and the Feb 2020 labor force of 1645K, there would be around 129K unemployed people, and the headline unemployment number would be around 7.8% against the official June 2021 figure of 5.9%. Both Fed Chair Powell and U.S. Treasury Secretary Yellen are pointing out this issue of pre-COVID labor force participation numbers and headline unemployment numbers. At any rate, the Fed is projecting an unemployment rate of around 4.5% in 2021, 3.8% in 2022 and 3.5% in 2023.
The Fed will now wait for December 2021 unemployment data (headline rate and labor force participation) as by September 2021, the extended PUA (pandemic unemployment assistance) will expire, which is a big factor for some low paid (minimum wage) workers, who are now enjoying earnings (without any work) almost equal to pre-COVID earnings (with work).
Also, some other factors like child care and vaccine hesitancy issues are holding up employment. As children below 12 years of age are yet to be vaccinated, schools can't open physically and thus it's very difficult for the single working parent to return to work physically while leaving children alone at home. Normally, U.S. public schools function as free day boarding schools to take care of children's every need.
Another factor is vaccine hesitancy for a large part of the U.S. population. As of 31st July, the U.S. fully vaccinated (2 doses) around 50.1% and 58.2% partially (at least 1dose). It seems that despite surplus vaccines, almost 50% or roughly 100M of eligible Americans are hesitant to take the COVID vaccines, especially in many Republican states and vaccination is now becoming a political rather than health issue for them.
Now the COVID Delta variant is taking the shape of another pandemic in the U.S., largely among such unvaccinated people:
Although a new COVID mutant like the Delta variant may also infect a partially/fully vaccinated person, in most cases, it would be mild and does not cause hospitalizations or death. A vaccine is not a guarantee but an assurance against possible infection. The vaccine prepares the immune system of the body in advance to fight the targeted virus by already producing antibodies. Now, depending on the levels of antibodies in the blood (after vaccinations or natural infections/recoveries), or the memory function of T+5 cells to memorize the earlier virus/antibodies, the body will fight the virus, in most cases at very primary stages (asymptomatic), causing virtually no infection or, in some cases, at later stages, which will cause only mild infections/symptoms. Thus, it's the human body's immune system which ultimately fights and cures any viral infections in most cases, not the vaccine itself per-se.
The Fed will watch the pace of COVID vaccinations along with real economic data:
The Fed actually projected +0.25% sequential inflation (m/m) for 2021, leading to a 12-month average rate around +3.0%. Now, as of June 2021, the average run rate is around +0.37% (m/m). At this average run rate, the 2021 core PCE inflation will be around +4.4%, substantially higher than the Fed's 2% target and not moderately above the +3.0% projected.
Also in 2022, the y/y inflation will be less (towards 2%) as the 2021 base is higher. The Biden administration is also pleading with unvaccinated hesitant Americans to get vaccinated as soon as possible; otherwise many Americans may not be able to work even after PUA ends. Thus, the Fed would like to wait for 2021 before any QE tapering decision, treating it as a 'year of transition' from the COVID disruption, from the point of view of both employment and inflation. The Fed will judge data from early 2022, which should be free of any idiocentric factors. By December 2021, the U.S. should also make substantial further progress on the COVID vaccinations front; the COVID curve should also flatten substantially further by December 2021 on a durable basis if vaccine hesitancy reduces significantly going forward.
The Fed will go for QE tapering when its sees 'substantial further progress' of its maximum employment (as per the Fed's standard-inclusive, broad-based and adequate wage/wage growth) from December 2020 levels and core PCE inflation (average over certain years) is around +2.0% and is in the process to be moderately higher for some time.
And the Fed will go for gradual rate hikes when it sees the economy is at or very close to maximum employment, say an unemployment rate of 3.5% and core PCE inflation (average over certain years) is around +2.0% on a sustainable basis. From the Fed's latest projections, the Fed sees QE tapering from December 2022 and gradual rate hikes from December 2023.
Overall, the Fed and Powell are trying their best to delay QE tapering and eventual rate hikes as long as possible (lower rate for longer policy) to pave the way for lower borrowing costs for the U.S., and to fund growing debt to rebuild America (fiscal/infra/COVID stimulus). The Fed must keep U.S. 10Y bond yields around 1.30% or below so that overall U.S. borrowing costs remain around 10-12% of its tax revenue, despite increasing borrowing amounts in 2022-23.
Inflation compulsion may force the Fed to act sooner rather than later:
But despite a transitory, lower base narrative, the headline U.S. CPI inflation is now running at +5.4% (May 2021) on a y/y basis and the Fed/Powell are under huge media and political pressure to act. Many young Americans haven't seen such inflation in their lifetime. The surging inflation is already affecting Real Street irrespective of Wall Street's transitory narrative; it's becoming a hot political issue ahead of the 2022 mid-term U.S. election and Biden may not allow hotter inflation for longer.
Thus Powell and the Fed have to act by March-June 2022 for QE tapering. And in the meantime, the Fed will keep inflation expectations around 2% (despite headline inflation now around 5%) and U.S. 10Y bond yields effectively below 1.30% by jawboning (forward guidance) and back door QE tapering (daily reverse repo to the tune of almost $900B). The Fed is already sucking excess liquidity from the banking system to tame inflation. They are also preparing the global market for any adverse Taper tantrum effect (USD shortage) by the introduction of standing repo facilities with various foreign central banks.
Going by the present trend of U.S. core PCE inflation of around +0.37% m/m trend (average), the 2021 core PCE inflation may be around +4.4% instead of the Fed's projection of +3.0%, substantially above their assessment/target (not moderately above as per Powell's admission). Thus, the Fed is bound to act on QE tapering earlier by March or June 2022 or even December 2021 instead of December 2022.
If U.S. annual inflation indeed surges well over +6% in 2021, it will become a hot political and media issue for the Biden administration, and thus the Fed has to act, whatever the narrative may be. Biden may not compromise on additional fiscal stimulus for around $3.5T (including infra $1.2T), But Biden may also roll back Trump tariffs on Chinese goods, which may help to tame imported inflation on ordinary American daily lives to some extent.
USD is also being helped by huge monetary policy divergence between Fed and BOJ:
On the other side of the Pacific, Japan is far behind the U.S. in the COVID vaccination pace. By July 2021, Japan vaccinated around 29% of its population fully (2 doses) and 40% partially (at least 1 dose). As a result, Japan is still under COVID disruptions with lingering lockdowns. Japan is also using the mostly adenovirus (1st generation) vaccine platform against U.S.'s mRNA (2nd generation) vaccine platform; it seems that the mRNA vaccine platform is performing better than the adenovirus platform.
In 2021, the Japanese core inflation is increasing by around +0.05% on a sequential basis (m/m), translating to an annualized rate of around +0.30% (y/y), far below the BOJ's target of +2.0% on a sustainable basis despite the global transitory narrative. Thus, the BOJ is not even thinking about any QE tapering or rate hikes and may continue to be at NIRP, YCC mode perpetually, unlike the Fed, which is now thinking about normalization and may normalize by 2022-23. So, there is a huge policy divergence between the Fed and the BOJ, and JPY turned into a funding rather than a growth currency, thanks to Japan's deflationary and stagnant economy. This 'Japanification' is helping USD against JPY.
Technical View for 2021: USD/JPY (LTP: 109.20)
Technically, whatever the narrative may be, time and price action suggests USD/JPY trading price now has to sustain over 109.20 for 110.35-110.85 and further 112.75; and only sustaining above 112.75, it may target 114.50-114.75 areas in 2021. On the other side, sustaining below 108.90, USD/JPY may target 107.45-106.00, and only sustaining below 106.00, it may further fall to 104.40-103.90 zones in 2021.
As the Fed will
eventually signal QE tapering by the next few months and rate hikes
(normalization) as discussed above, the probability of USD/JPY breaking below
108.90 is less unless Powell and the Fed dial back the normalization narrative.
The Fed is already discussing QE tapering quite actively and preparing the
market for the eventual normalization. The Fed always likes to prepare for the
next financial crisis, unlike the BOJ, which hasn't been able to 'exit' the
NIRP/YCC (negative interest rate and yield curve control policy) after the 2008
GFC.
USD/JPY - FIBB
USD/JPY - Pattern/Trend line
