FX Required Information - Foreign Exchange Market and Interest Rate Differential 2022/08/12 (Fri)

The current market theme is "When will the Fed start cutting rates?"

The key point is that, in order to cut rates,

(1) it must be clearly evident that inflation has fallen to 2% or lower.

(2) employment growth must shrink to the point where a cut becomes unavoidable.

On this point, there is a gap between market expectations and the Fed's stance.

(1) The market views a main scenario of rate hikes ⇒ economic slowdown & price moderation ⇒ rate cuts, and believes the Fed will pivot to cutting rates next year. In that context, among the two factors that push prices up (rising goods prices and rising wages), goods prices have begun to fall, and the rapid decline in the month-over-month inflation rate in July has given the market a sense of forward momentum.

(2) The Fed, even with a decline in goods prices, seems to imply that this alone won’t bring inflation back to 2% or lower, showing little concern about this issue (no explicit mention). What they are focusing on is the wage growth rate.
The Employment Index remains “still solid, with hardly any signs of hiring freezes or job reductions,” indicating wage-cost pressures and suggesting the Fed has no intention of loosening the reins on rate hikes.

In short, the market expects a slowdown in the economy to lead to a drop in wage growth, but the Fed believes the labor market remains tight and that wage growth will not easily fall.

Last week, among the two inflation drivers (rising goods prices and rising wages), goods prices have begun to fall, and the rapid decline in the July month-over-month inflation rate led the market to feel a sense of forward momentum.As a gut feeling, inflation that had been up 8% year over year fell to 4%, suggesting inflation is cooling.
Interest rates fell, the dollar weakened, and stock prices rose (easing monetary tightening → higher P/E). Notably, the stock market experienced a short squeeze and rose sharply.

Personally, I align with the Fed viewpoint, so I continued holding a long dollar position since the end of last week, but the CPI release caused the dollar to fall. However, since it dropped into the 132-yen range, I bought dollars at 132.50. I intended to average down in 1-yen increments, but the 131.50 limit order did not execute. In the end, last week started at 135.0 and closed at 133.50. Including the carried position, my assets slightly decreased.

Now, to the main topic: the relationship between the exchange rate and interest rate differentials, and the outlook going forward.

The relationship between the exchange rate and the interest rate differential is essential information for those watching currency movements.

Exchange rates are dictated by supply and demand, but one major factor driving the demand and supply of exchange rates is the interest rate differential.

The relationship between exchange rates and interest rate differentials is the most important and fundamental concept for FX.

It is necessary to constantly understand this relationship.

This relationship is not permanent; it often changes form.

We regularly monitor information about this relationship.

Below are the regular graphs (USD/JPY, EUR/USD, GBP/USD, AUD/USD, EUR/JPY and their respective correlations with interest rate differentials).