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13 Jul 2023

Widening rate differentials pose a threat.

Countering long-standing market consensus, the Bank of Japan could remain cautious, maintaining its ultra-accommodative policy stance in the face of quickening domestic inflation. A renewed rise in energy prices might generate a negative currency shock via a renewed deterioration in the country’s flow dynamics. Alternatively, an extended run of stronger-than-expected global activity data – potentially paired with persistently-sticky inflation – could lead to a widening in interest rate differentials (although we note that the likely negative implications for global growth and risk appetite could act to limit the extent of any yen weakness in markets). World industrial indicators and Japanese...

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Rate differentials should remain supportive.

A relative softening in both headline and core consumer price measures has allowed the Banco de Mexico to shift onto a data-dependent footing in recent months, using forward guidance to signal an extended pause ahead. Markets think rapidly-decelerating inflation and a deteriorating growth outlook will force central bankers into a u-turn in the fourth quarter, with implied prices pointing to at least two rate cuts by the end of the year. We aren’t confident this will pan out – Mexican policymakers have traditionally waited for a reversal from the Fed before launching their own easing cycles, and are unlikely to...

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Japan remains a rock in a sea of troubles.

In our view, a bullish scenario for the yen (against the dollar and other majors) might unfold if the developing global economic downturn becomes more pronounced, with the negative feedback loop into markets larger and broader than anticipated. Periods of heightened financial stress are typically supportive for the currency as Japanese investors tend to repatriate capital allocated overseas during market turbulence. Another yen-positive development could emerge if the Bank of Japan surprises and normalises its policy settings more quickly and abruptly than envisaged. We would note that market expectations for a change at any time soon appear low. More assertive...

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Exogenous forces could collapse the carry trade.

Political uncertainty is growing ahead of the 2024 election, and the ruling Morena party may be tempted to deploy the public balance sheet in drumming up support – but the fiscal outlook should nonetheless remain far stronger than many of Mexico’s emerging market peers. Instead, we think the biggest threats to the peso’s current valuation could come from abroad. Renewed currency intervention – or a more hawkish reset in Japan’s monetary policy stance – could trigger a surge in the yen and squeeze traders with leveraged positions – forcing a selloff in the peso. Under another scenario, a pronounced downturn...

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Economies are proving remarkably resilient.

The last year and a half should have been disastrous for the global economy. Russia’s invasion of Ukraine upended supply chains and sent energy prices soaring. Chinese authorities forced hundreds of millions into lockdown. High and persistent inflation forced central banks to raise interest rates at a pace unequalled since the 1980s. Housing markets tumbled. Bank failures triggered unease at the very core of the financial system. Political brinkmanship brought the US to the edge of default. Yet, over and over, worst-case fears in markets and boardrooms have gone unrealized. European economies retooled at lightning speed and a warm winter...

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