Asian Markets Rebound and Yen Weakens Amid BoJ Comments

Asian stocks have rebounded overnight, and the Japanese yen has weakened more than 2% against major peers like the US dollar and British pound. This shift follows comments from Bank of Japan’s (BoJ) Uchida, who raised concerns about the recent volatile market moves and alleviated rate-hike anxiety with dovish remarks. The yen’s slump is being welcomed as it reduces the potential for fresh, rapid carry trade unwinds and the resulting deleveraging impulse across the broader financial system.

Nevertheless, the recent unwinding in carry trades could have more room to run, as the yen remains one of the most undervalued currencies. This trade has been pummeled over the past month, particularly in the past week, leading to the yen’s realized volatility spiking to its highest level since the pandemic. The significant shift in trading activity was exacerbated by the BoJ’s rate hike last week and growing fears of a looming US recession. However, the Federal Reserve (Fed) Bank of San Francisco President Mary Daly helped soothe recession concerns by stopping short of concluding that the labour market has begun seriously weakening. Other Fed officials, who have spoken since the release of the dismal US jobs data from July, have also cautioned against reading too much into one employment report.

Global risk appetite has since improved, with the Nikkei rebounding 2.8%, nearly returning to its position before Monday’s 13% crash. Euro Stoxx 50 futures have advanced 1.3%, alongside gains in US futures. Treasuries have fallen along with safe-haven currencies like the Japanese yen and Swiss franc. The US dollar index has bounced from 6-month lows due to gains against the yen, but it remains softer against pro-cyclical currencies – a pattern that may persist now that the dollar’s rate advantage has been trimmed with four Fed cuts priced in for 2024.

British Pound Declines Amid Reduced Rate Expectations and Carry Trade Unwinds

After trading near €1.20 just a few weeks ago, the British pound has now dipped to just above €1.16 against the euro, falling below key daily moving averages. This decline has reversed much of its year-to-date rally, in line with decreasing expectations for UK interest rates and the unwinding of carry trades, which has negatively impacted global risk sentiment.

Despite the somewhat hawkish Bank of England (BoE) rate cut last week and assurances from Governor Andrew Bailey and Chief Economist Huw Pill that further rate cuts are likely some months away, markets are pricing in another 42 basis points worth of easing before year-end. The rate differentials had already suggested that sterling was overstretched, particularly against the euro, making the GBP/EUR decline unsurprising. The upcoming UK inflation data for July, set to be released next Wednesday, will influence the timing of the next rate cut, although the BoE expects inflation to rise to 2.75% by year-end and has stated it won't react to a single month's data surprises. This outlook likely rules out a rate cut in September, despite markets currently pricing a 47% chance of one.

Heightened global growth concerns and a sharp global equity market sell-off have further complicated the outlook. If the BoE adopts a more dovish stance in the coming months, sterling’s upside potential could be limited before year-end. In the shorter term, considering GBP/USD, August has historically been the pair’s weakest month of the year, with average returns of around -0.80% since 2000.

German Bond Yields Rise as Risk Appetite Returns, EUR/USD Declines

German bond yields moved mostly higher across the curve, lagging behind US Treasuries, as risk appetite returned following a sharp selloff at the start of the week. European stocks, apart from the French CAC 40, climbed as dip buyers emerged. Consequently, EUR/USD surrendered a portion of its recent gains amid soft mean-reverting behaviour. While volatility is noticeably lower, further flare-ups, especially around US labour market reports, cannot be ruled out.

Investors have aggressively priced in an increased risk of a US recession following last Friday’s labour market report, whereas the outlook in Europe remains less clear. Eurozone retail sales fell 0.3% MoM in June, more than the expected 0.1% decrease, driven by a marked decline in sales of food, drinks, and tobacco products. The HCOB construction PMI edged down to a six-month low in July, with activity and output declining significantly, particularly in housing. New business also fell amid weak demand, sparking further job shedding. However, German factory orders rose by 3.9% MoM in June, surpassing market forecasts of 0.8%, marking the first increase since last December. Foreign orders gained 0.4%, with orders from outside the Eurozone rising 0.9%, while orders from within the bloc fell 0.3%.

ECB officials must balance the growth picture in Spain and Italy, which are proving more resilient than Germany. Money markets are betting on the ECB cutting rates by 24 basis points in September and pricing in around 72 basis points by year-end. With relatively stable ECB rate expectations, recent volatility stemmed from the aggregate repricing of Fed easing. As the US rate moves appear exaggerated and are already correcting, scaling back Fed easing expectations suggests some upside risks for the greenback, albeit at a structurally lower level compared to last week.