Will USD/JPY hit 130? Beware of broad FX sell-off

Investors continued to buy U.S. dollars, driving the greenback to its strongest level against the Japanese Yen in more than 6 years. The biggest driving force for USD/JPY right now are U.S. yields which have been in a relentless uptrend for the past 2 months. Today marks the seventh consecutive day of gains for 10 year yields which broke above 2.7%. To put this into perspective, just over a month ago 10 year rates were hovering under 1.8%.  
 
Investors are convinced that the Federal Reserve will raise interest rates by 50bp at their next meeting as high prices persist. This is consistent with everything we’ve heard from Fed Presidents last week. We’ll hear from more policymakers this week and they are widely expected to reinforce the central bank’s hawkish views.  The upcoming inflation and consumer spending reports should also harden the case for aggressive tightening. CPI will be hot and retail sales will be supported by higher prices, higher wages and strong labor market conditions. The big question is how much further can USD/JPY rally? The closest resistance level is the May high of 125.86 but if this week’s U.S. economic reports surprise to the upside we could easily see the pair move to the April 2001 high of 126.85 and then 130. 
 
In addition to these pieces of market moving U.S. data, there are also three central bank rate decisions on the calendar and two are expected to raise interest rates. The Reserve Bank of New Zealand meets first on Wednesday morning local time and they are expected to lift rates for the fourth time by 25bp. Some economists are looking for a larger 50bp hike but with supply constraints, rising prices, the lockdown in China and slower global growth, the RBNZ who has already raised rates by 75bp is likely to opt for a more conservative adjustment. By doing so, they would gain the flexibility of seeing how the market responds to Fed tightening and how the Russian invasion of Ukraine plays out. 
 
The Bank of Canada on the other hand is wildly expected to raise interest rates by 50bp. This would be the second back to back rate hike from the BoC and the largest one month increase since 2000. Unlike the RBNZ, the Bank of Canada has only raised interest rates by 25bp and a half point move would bring rates to 1 percent. Even without the pressure of rising prices, the strong labor and housing markets support policy normalization. With inflation at a 30 year high, the BoC will most certainly step signal further tightening beyond this week’s move. Rates could easily hit 2.5% by the end of the year.  
 
Unlike the RBNZ and BoC, the European Central Bank is not expected to raise interest rates. Although high inflation is also a problem in the Eurozone, growth is hampered by sanctions on Russia, supply chain issues and the shock of higher food and energy costs on consumers.  The rise in long term rates across Europe should help to cool prices. Even if the ECB can’t raise rates this week, there are steps that can be taken in that direction. The most important of which is addressing their Quantitative Easing program. Previously, the ECB said rates won’t increase until asset purchases end. The choice now is to end QE immediately or to shift guidance by suggesting that rates could increase as QE is unwound. We expect the ECB to raise interest rates this year but the move may not happen until the late third or early fourth quarter which leaves the central bank far behind its peers – a predicament that is negative and not positive for euro.  
 
With the prospect of global tightening, ongoing Russian-Ukraine conflict, stress of high prices, supply chain issues and the COVID-19 crisis in China, we expect risk appetite to take a turn for the worse. The Dow Jones Industrial Average dropped more than 400 points today and while currencies held steady, a broad based sell-off may be right around the corner.