BNY Mellon: Corrective Behavior?

23 jan 2019

By Simon Derrick, Chief Currency Strategist, BNY Mellon

By Simon Derrick, Chief Currency Strategist, BNY Mellon

The net impact of the wave of China-related headlines over the past few days - ranging from a continued slowing in the growth rate through to a cautionary report on the state of negotiations between Washington and Beijing - has been to dampen some of the positive market sentiment that’s been evident since the first week of this year.

This shift was most clearly seen in the poor performance of the CSI 300 on Tuesday, which witnessed its worst daily decline since the start of the year. This, in turn, brings the focus back to bear upon two key barometers of market sentiment: AUD/JPY and CAD/JPY.

The rebound seen in both pairs since the start of the year has followed a similar pattern to that seen in 2008, with sharp gains early on driving a spike in realized volatility.

However, upward momentum has been fading in recent days as sentiment about the outlook for the Chinese economy has begun to turn more cautious.

Given this decline in upward momentum, it’s therefore interesting to note that there has been little sign of any major volume being behind the recent weakening in the JPY, with our own iFlow data showing flows remaining relatively muted since the start of the year.

At the same time there has been little to suggest a pick-up in appetite for either the CAD or AUD - in fact, much the opposite has emerged.

That fuels a suspicion that much of what’s been seen this month has been corrective in nature.

Although it’s certainly true that the CAD currently enjoys better levels of yield support against the JPY than it has for most of the past decade, it’s worth noting that the yield gap between two-year Canadian and the equivalent Japanese government paper still only stands at roughly the same level as that between JGBs and Australian government bonds.

This latter gap, in turn, remains at close to the narrowest levels seen in nearly three decades. To put this into context, it would only take four daily moves lower on the scale seen yesterday for the AUD to entirely wipe out its yield pick-up for the year.

There’s a simple “so what” to this. JPY crosses have had something of a history over the past three decades of having a very narrow exit door when JPY-funded positions are unwound and/or Japanese investors look to bring money back home. 

This is understandable given that the relatively high cost of owning JPY typically discourages investors from being long of the currency unless it’s absolutely unavoidable. 

If what has emerged over the past few weeks is no more than a correction then the risk is that with China growth concerns continuing to be flagged up, the next move to the downside for these crosses could prove abrupt.