Today’s Fed minutes could undermine the risk rally further especially if they highlight that there was a range of views on the pace of rate normalization in March. The release will strengthen the market view that the dovish Yellen comments of late need not imply that the FOMC will ignore the accelerating US core inflation for a long time. In particular, we expect to learn more about the debate at the Fed about the merits of hiking gradually but promptly in the early stages of the cycle to avoid sharp and disruptive tightening later on.
In addition, the minutes could highlight that the policy makers saw only temporary downside risks to the recovery emanating from the persistent global headwinds. The Fed minutes could help the beleaguered USD consolidate even if mainly against G10 commodity currencies.
EUR/USD remains close to recent highs and USD/JPY seems on the verge of breaking to new lows. More constructive Fed minutes may change little especially if market risk sentiment remains fragile in the very near-term.
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The above being said, we think that the downside risks for EUR/USD could intensify going into the ECB minutes on Thursday. Indeed, given that one important support for the latest EUR rally has been the apparent abatement of the global currency war, evidence that the Governing Council remains open to more easing (e.g. in the form of more negative deposit rates) could send the EUR lower yet again. Longer-term, we expect that investors will become more cautious on the single currency as the EU referendum draws near. The underperformance will be driven by investors realization that a potential escalation in Brexit risks should weaken the bond holding the EU together and weigh on the Eurozone recovery from here.
In the case of USD/JPY, it remains under pressure on the back of lingering risk aversion and market’s perception that the BoJ is out of options to cheapen the currency - eg an official FX intervention seems less likely for now even if you could make the case that the recent moves in the currency have been quite violent. We further suspect that persistent outflows from the Japanese asset markets are encouraging foreign investors to unwind short-JPY hedges and support the currency.
All that said, we still think that the long-term risks for JPY are on the downside. We expect the BoJ to announce further policy measures before long and that could encourage further outflows of excess savings from Japan and encourage foreign investors to buy Japanese stocks and sell JPY.