An early Fed rate hike pushing US real rates up will not bode well for risk appetite and related financial conditions.
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An economy with high leverage and low returns of investment requires real rates to stay low to avoid a growth outlook damaging appreciation of real debt. The Fed's Dudley accompanied by overnight comments from Lockhart keeping the door open for a rate hike in September or December try to keep the Fed with optionality. However, given the relationship between real rates, the equity market and financial conditions, we believe the Fed may constrain itself from hiking early. If the Fed does not constrain itself, any USD rally will find its limits in a subsequent decline of financial conditions and the Fed moderating its rhetoric once again.
Against this backdrop USDJPY has more downside potential. Verbal intervention by Japan's MoF's Asakawa should not help USDJPY for long. Should the Fed's hawkish rhetoric drive real rates higher, risk markets are unlikely to withstand this pressures, providing a repatriation bid for the JPY. If our base scenario works out suggesting the Fed keeping rates unchanged for this year and next, the USD will remain under general selling pressure. An additional factor suggesting a lower USDJPY is the rise of the US LIBOR rate due to regulatory changes. Japan's corporate and financial sector has used the US Prime money market for funding. The increased cost of this funding tool suggests these companies may use JPY over USD funding
A similar constellation plays in for the EUR. The chart below shows that Japan's life insurance companies have generally FX hedged a higher proportion of their EUR assets relative to USD assets, suggesting that need to hedge existing EUR asset positions is less and so adds to our EUR bullish views.