Since the COVID low in US Treasury rates and subsequent rise, the Japanese Yen has tracked the yield differential between the US and Japan. With the Federal Reserve having embarked on a rate hiking cycle, the monetary policy divergence between the US and Japan has grown. Has the decline in the Yen gone too far?

10-Year US Treasury yields made a high of 3.21% on June 14, three days before the June 17 low in the S&P 500. Since then, US rates have been declining as recession fears heighten by the day in the US. Now a measurable gap has opened up, suggesting the full extent of the Fed’s hiking is priced into the market. With yields having backed down to 2.58%, the JPY has notched over (getting stronger). At current rates, the relationship between rate differentials and currency values suggests that the Yen should be trading closer to 130 to the USD.

Why has the bond market rallied, taking rates down by 60bps over the last six weeks? Simple: recession fears. Last night’s earnings guidance reduction from Walmart is a great anecdote suggesting the consumer may be starting to weaken.

The Conference Board’s Leading Economic Indicator (LEI) has been declining for four months now. If I take the monthly change and annualize it, I get a reading of -9.6% currently. The US has, with no exceptions since 1960, been in recession when the LEI is -9.6% or lower.

As Barry Eichengreen wrote in yesterday’s FT (Is the dollar about to take a turn?):

“Thus, the expectation of further rate rises from Fed chair Jay Powell and others is already in the market. There is no reason why those additional policy rate increases should move the dollar any higher, in other words…  So if the economy and inflation weaken, the Fed will pause, and the dollar will reverse direction. This is no longer a risk that can be dismissed.”

As of 6/30/22, Walmart was not held in the Knowledge Leaders Strategy.