Uncertainty is holding traders back, and they await more information about anything before positioning

Outlook

After last week’s freakout, traders worry whether we might get another one. Unless the new data this week is really bad, we’d say no. In fact, it looks like uncertainty is holding traders back and they await more information about something, anything, before positioning. That includes any tidbit of info about the carry trade (see below) but Japan is closed today, so Monday could be eerily calm.

New info is thin—we get the NY Fed inflation expectations survey, forecast to be tame.

We get PPI on Tuesday, CPI on Wednesday and retail sales on Thursday. In the UK, we get CPI and GDP. Before those, it’s the Reserve Bank of New Zealand, which always punches far above its weight. We might even want to watch the Thursday jobless claims. And next week is the Jackson Hole shindig. See the dandy Reuters chart.

The preponderance of CPI forecasts are not scary, but nerves are frayed anyway, and never mind that the Fed cares about PCE, not CPI. High numbers would be bad for everything financial. Last time, core CPI fell to a 3-year low of 3.3%, and even shelter fell a little (to 5.2%). Shelter has been the guilty party for a long time, accounting for two-thirds of the core CPI. It would be nice if everything dipped a little more. The consensus forecast for core CPI is 3.2%.

The Yen: Nobody knows how big the carry trade had gotten and therefore nobody knows how much of it has been unwound. Bloomberg quotes one expert: “The death of the carry trade is being called a little bit prematurely.” Citi says the unwinding has taken markets out of the “danger zone.” Standard Bank London says something similar: “Further carry-trade unwinding seems likely but the most significant and destructive part of this bubble-burst is now behind us.” BNY thinks the unwinding can go further and will take the dollar/yen to 100. 

What are the economics behind the carry trade in the first place? The do not really make the Bank of Japan the villain for having defied global anti-inflationary fat rate hikes by keeping rates at zero. With yield differentials like that, of course the yen was going to devalue, which in turn is very nice for exports.

But as many have noted, a weak yen has drawbacks that can easily outweigh benefits, and in any case, the BoJ didn’t want to raise rates for two good reasons: Japan didn’t have killer inflation and raising rates could have driven some companies down the drain.

The worst inflation in Japan was 4.3% in Jan 2023. For most of the past five years, though, inflation has been barely over 3% and most recently, 2.6-2.8%. We have had Trading Economics’ “Japan Inflation” bookmarked for years. The BoJ didn’t hike because it didn’t see the need to hike and the drawbacks outweighed the benefits—the chief benefit being in line with the rest of the G7 world. 

Here's where villainy comes into it. Japan knows all about the carry trade and could have  written a regulatory rule limiting carry trades. Japanese banks are famously obedient. It could have been made to work. Let the domestic entities do it, but not the foreign owned hedge funds and others. Or limit the amounts for everybody.

But we can probably safely assume that the US and other G7 bigshots would frown on regulation of that sort, considering it improper currency manipulation (or something). You have to wonder if the Mof queried the US Treasury about imposing carry trade regs. The BoJ was always between a rock and a hard place.

The narrative today is that the BoJ had to retreat and will stay holed up in a cave until the dust settles. But that’s not realistic. BoJ chief Ueda has said repeatedly he wants to get Japan’s interest rates “normalized” and that means back in sync with the rest of the world, He will act again when the markets have calmed down (and attention turned elsewhere), Wall Street’s druthers notwithstanding. There should be a betting parlour for the next BoJ rate hike. It’s not far off forever. 

In the meanwhile, whither the dollar/yen and euro/yen? Charts are of no use in considering a question like this. How about purchasing power parity? The OECD has a weird chart that indicates the dollar/yen should be 98+. 

Wait, it gets worse. The Economist Big Mac evaluation of PPP has the dollar 78.4% overvalued against the Japanese yen. The pound is 84.8% overvalued against the yen, and the euro, 89.9%. [The site is fun to play with—it has the dollar undervalued against the euro by 6.1%, dated end-July].

Purchasing power parity is two things at once—actually quite accurate but not a reliable predictor of market outcomes in a short timeframe. As for accuracy, the implication is that sometime in the next 12-18 months, the dollar/yen will go to a number closer to 100 than to the recent highest high of 161.80. That’s if and only if the BoJ is able to start acting again.

In the meanwhile, does the dollar/yen make another run at 161? The current upward correction is just that, a correction. It “should” come to an end somewhere around 150 with 155 a max. Just guessing, but if the BoJ believes it can’t act on rates, it can still intervene. Over the weekend, JP Morgan revised its forecast to 144 by Q2 next year, with consolidation the fate in coming months. It also believes 67-75% of carry trade positions have been unwound.

Well, maybe. Reuters reports that leveraged funds' position in the yen contracted to the smallest net short stance since Feb 2023, according the CFTC on Friday. 

Food for Thought: We had a one-time and brief normal yield curve last week on Monday, when the 10-year yield was higher than the 2-year--for the first time in two years. This is dis-inversion or un-inversion, something the anti-recession crowd has been praying for. The event is not an Event because it was short-lived and caused by hysterical stock market behavior that drive cash to T-bills, but triggered talk of dis-inversion actually being the signpost to recession.

Don’t buy it. It was a fluke. As with everything else at the 3-way intersection of economics, institutions (central banks) and markets, there is lag all over the place. They never arrive at the same place at the same time. Critics like to blame the Fed for always being behind the curve. This is (mostly) true, and so what? We wouldn’t want a trigger-happy Fed. That brings up the question of when the 2-year will actually go back to the dis-inversion level.—and stay there.

The St. Louis Fed has the diff at -0.11% on Friday—wow. See the chart. It’s the least since July ’22, or two years. But there’s plenty a slip, etc.  We’d guess it will take at least one more quarter or perhaps two for the dis-inversion to be done and dusted, Re-read that word “guess.”

Tidbit: One view from Wall Street is the BoA Data Analytics that gives us one of the most-cited bull/bear indicators. This time the reports says “technical levels that would flip Wall St narrative from soft to hard landing have not been broken.” That doesn’t mean we won’t get another freak-out, of course, but it does mean the gloomsters should shut up for a while.

Another noteworthy entry is that Wall Street really, truly wants a lower prime rate for smaller businesses that do need to borrow. The prime is 6.5%, higher even than in the 2007-08 crisis (Sept ’07). So, not tiny little cuts, but big, fat ones, please. There’s more, like “Wall Street stopped the BoJ rate hikes,” which is not known for sure. Again we have to vote that the Fed doesn’t give a fig for the stock market, or maybe only a very small one.

Forecast

The dollar “should” have benefitted from the yen crisis and the stock market freak-out, as in past crises both real and made-up, but it took a while for the market to realize it. We expect the exaggerated rate cut scenario to start getting a haircut this week or next, although that assumes CPI inflation doesn’t scare everyone all over again. The drop in rate cut expectations from 100 bp to 50 bp this calendar year “should” be dollar-friendly, although it may not arrive in full this week. 

Political Tidbit:  The polling just keeps getting worse for Trump. The latest poll from The Economist has Harris at 47.5 vs. Trump at 45.8. We must always remember that this is the popular vote, not the Electoral College vote, which (as some folks say) gave the 2016 election to Trump on flukey outcomes in just a few states.

The NYT has that covered. From the front page of the Saturday edition, Harris leads in three of those seven Electoral College-critical swing states. Then there is the betting, which can be uncannily prescient.

Not that most voters will know or care, but VP candidate Vance said on Sunday TV that interest rate decisions should be political, as Trump said. This is a guy who knows no financial history.

And a miracle: the FT reports its survey, commissioned from the University of Michigan Ross School of Business “is the first monthly poll to show the Democratic presidential candidate leading Trump on the economy since it began tracking voter sentiment on the issue nearly a year ago.. Harris has one point more than Trump (42% vs. 41%), which is not worth reporting except this is a 7% gain over Biden’s number in July. Voters are wrongly negative on the economy and wrongly blame Biden, so Harris’ econ policy this week had better not seem like more of the same. 

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