Interest rates have some way to go before they take over from risk aversion as the key driver of currency markets but as noted in my previous post, low US interest rates have played negatively for the dollar. As markets have continued to pare back US tightening expectations and US interest rate futures have rallied, interest rate differentials have moved against the dollar.
The most sensitive currency pair in this respect has been USD/JPY which has been the most highly correlated G10 currency pair with relative interest rate differentials over the past month. It has had a high 0.93 correlation with US/Japan interest rate differentials and a narrowing in the rate differential (mainly due to a rally in US rate futures) has resulted in USD/JPY moving lower and the yen becoming one of the best performing currencies over recent weeks.
Going forward the strong FX / interest rate correlation will leave USD/JPY largely at the whim of US interest rate markets (as Japanese rate futures have hardly moved). Fed officials if anything, are adding to the pressure on the dollar as they continue to highlight that US interest rates will not go up quickly. San Francisco Fed President Yellen was the latest official to do so, warning that the prospects for a “tepid” recovery could fuel inflation risks on the downside.
This echoes the sentiments of other Fed officials over recent weeks and suggests that the Fed wants to prevent the market pricing in a premature reversal in US monetary policy. It looks increasingly likely that the Fed will maintain interest rates at current levels throughout 2010 given the massive amount of excess capacity and benign inflation outlook, suggesting that interest rate differentials will play negatively for the dollar for several months to come.
As for the yen its path will not only depend on relative interest rates but also on the policies of the new DPJ led government. If Japanese press speculation proves correct the new Finance Minister may favour a stronger yen which will benefit domestic consumers rather than a weaker yen that would benefit exporters. Against this background, markets will largely ignore comments by outgoing Finance Minister Yosano who said that further yen strength would be detrimental for exporters.
The market certainly believes that the yen will strengthen further as reflected by the sharp increase in speculative positioning over recent weeks; net CFTC IMM long yen positions have reached their highest since 10 February 2009. Although USD/JPY has pushed higher since it’s low around 90.21 the upside is likely to be limited against this background and a re-test and likely break back below the key 90.00 psychological level is likely soon.