It’s hard to see a further decline in USD/JPY without another negative US shock

I suspect Bullard’s comments today and the strong US PMIs from S&P Global are a clue to what’s to come next week. Bullard has not completely abandoned its hawkish bent and the services PMI has been particularly strong.

It’s way too early to take our eyes off the banks but – like Bullard – I think there’s an 80% chance the banking problems will go away.

Where will this leave the market?

I think that leaves the two-year note yield of 3.77% too low. The fed funds market is pricing in 6 basis points at the next meeting, or about a 27% chance of an upside. That would take the fed funds to 4.75-5.00% and given that policymakers plan to keep it at that level, it’s hard to see a bigger disconnect unless the economic data sinks.

And that brings us back to the PMIs, which indicated the economy accelerating, without slowing down. The coming week includes:

• The Dallas Fed (Monday)
• Consumer Confidence (Tuesday)
• Richmond Fed (Tuesday)
• Door-to-door sales pending (Wednesday)
• Third US GDP reading (Thursday)
• PCE (Friday)
• Feeling U Mich (Friday)

PCE is the most important and the market would like to see some disconnect from the higher numbers in the CPI data or a drop in earnings, but I think what the latest episode of the Fed has told us is that the Fed is in no rush to stop the hikes, let alone cut.

So what will keep 3.78% on 2-year bonds — and USD/JPY at 130.80 by extension — if bank concerns fade?

Generally, the right bet is to follow the market and not the Fed forecast, but the January-February period proved that this is not always the case. However, I believe the Fed is focused on inflation and won’t blink at the first signs of a recession. Given the lags in the data, we may not even have clear signs of that until September, so pricing 100 basis points of cuts from there by the end of the year is going to cause real economic difficulties. Lately the market has been hovering around commercial real estate as a catalyst and I’m sympathetic to that, but with the slow turnover of 5-year leases, it’s likely to be a slow-motion event.

Finally, there is some support for USD/JPY up to 127.00, which makes a return to 138.00 and beyond a more attractive risk-reward proposition.