Final Frontier
I couldn't think of a more apt title to describe it but unfortunately its that of the worst Star Trek movie ever made. So couldn't think of anything better than a video clip thats a review about how terrible the movie really was. William Shatner had to apologize for it and take up commercials for Priceline to earn a living - which would've been a more profitable change of career if only he held on to his shares.
Anyways back to markets, the bond market has regained its "exalted vigilante status" and has forced central banks to return to inflation fighting credentials and hike rates. Norges Bank, RBNZ, BOE, Fed, BOC have started their hiking cycles with RBA and ECB expected to follow suit. But the final frontier is not yet won. BOJ remains adamant that its YCC policy is still appropriate and with its defense of the 25bp rate cap signaled to bond markets much like Viper to Maverick in Top Gun - "Top Gun rules of engagement are written for your safety and for that of your team. They are not flexible, nor am I. Either obey them...or you're history, is that clear?" Unfortunately, that has resulted in the yen becoming the escape valve with USDJPY moving 12% in little over a month - a 4 standard deviation move. The battle lines are drawn and the foreign exchange market smells blood - an unsustainable market condition creating an asymmetric opportunity reminiscent of Soros' breaking of the pound in 1992 when Britain was unable to sustain the currency above the lower band of the ERM.
The market is increasingly forcing the BOJ to choose between a rapidly weakening JPY or what increasingly looks like an unsustainable YCC policy in the context of rapidly rising global bond yields. And the "bond vigilantes" are unlikely to just quietly walk away this time without an bloody battle. My bet is the BOJ relents and in the very least widens the band out to 50bp or potentially even abandon the idea of strict YCC altogether and opt for a floating peg that is managed in context of global yields (similar to EURCHF peg becoming a soft flexible peg after the one time adjustment). Kuroda's recent assertion that YCC remains appropriate policy for Japan conveys little information about probability of shift in policy. After all, the only way to withdraw from a peg without massive losses is to do it suddenly and without any forewarning to the market. April 28th is a key date for the global bond markets because the battle for the Final Frontier is on.
History doesn't always repeat but it often rhymes. The bond market rally in the subsequent weeks post YCC announcement by BOJ in September of 2016 marked a yield low that wasn't breached till mid to late 2019. It would not surprise me if the global bond rout that would most likely follow the BOJ stepping away from YCC would represent the final flush setting an interim yield top that might stay in place for many quarters. Many will rightly point out that the conditions in 2016 were quite different when a notable regime shift followed with the election of Trump and subsequent pro-cyclical fiscal policy. However, I do think the PMIs were accelerating post-Brexit and growth impulse was already pointing towards higher rates and Trump election turbo-charged the move. This time around PMIs are decelerating and fiscal environment in US post-midterms is probably not going to be favorable one. In any case, historical comparisons are never perfect and nothing more than a guideline to frame the discussion.
In conclusion, long USDJPY (ideally via short dated options) and short 10-year JGB remains the right package of trades to persist with till the BOJ relents. At some point after that it might be worth thinking about calling a time-out on global rates higher trade.