Think inflation is heading up? Check out CAD/JPY

BY DEB SHAW | 

  • CAD benefits from rising crude prices, while JPY weakens on higher inflation
  • Given the current economic outlook, going long CAD/JPY looks compelling
  • Technicals and sentiment remains distant from extremes, meaning the pair can push higher

Ever since both crude oil prices and inflation expectations bottomed last summer, our view on inflation has become more bullish. Crude prices look set to keep rallying for the rest of the year, while inflation expectations can keep rising thanks to tax reform hopes. Given the Canadian dollar’s historical correlation with crude oil, the currency is likely to be supported by rising crude prices. On the other hand, the yen is likely to weaken as global interest rates rise relative to Japanese rates. Thanks to the Bank of Japan’s ‘yield curve control’ program, 10-year Japanese government bond yields are fixed at 0% and enforced through the bank’s bond buying and selling program. This makes the yen quite sensitive to changes in global interest rates.

 

Both fundamental and financial drivers can drive CAD/JPY higher

Looking at fundamental drivers, crude oil prices continue to rally given that demand growth remains well ahead of supply. Crude oil stocks are falling as a result, while the price of the commodity has been rallying. Given the importance of crude in the broader economy, increases in crude prices eventually filter into higher prices for most goods and services. As everyday prices increase, this is reflected in higher rates of inflation. We explained in these dynamics in more depth in a recent commentary on crude oil supply versus demand.

Looking at financial drivers, hopes for higher spending thanks to Trump’s tax reforms is also helping the inflation outlook. In a commentary published earlier today, we explained how the proposed tax reforms can accelerate both business and consumer spending. While the proposed changes are contentious, particularly as high income earners are set to lose key deductions relating to state taxes and real estate, we remain optimistic that the bill can get through Congress. While markets turned skeptical on Trump after he failed to enact changes to healthcare, the recent success of the budget resolution process was a significant legislative victory for the White House. Our view is that the odds of the tax bill getting through Congress are high, given that Trump is using the same playbook that he used for the budget resolution process.   

 

Technicals and sentiment both broadly supportive

Looking at technicals on a weekly chart of CAD/JPY, resistance based on the Relative Strength Index remains distant. The pair ran into resistance after a strong run in November 2016 (on expectations of accelerating inflation following Trump’s victory in the elections) and again in the summer of 2017 following the Bank of Canada’s surprise interest rate hikes. In recent times, the pair has sold off as the Bank of Canada looks set to shift into neutral. This is illustrated below:

CAD/JPY can keep pushing higher from here, resistance not an issue today

11-3-2017 CADJPY

 

Lastly, investor sentiment is also supportive of the trade. Looking at our latest analysis on the Commitments of Traders report, Canadian dollar long positions were in extreme territory last week. Following the Bank of Canada’s “cautious” outlook on future rate hikes, we expect this position to fall in the next few weeks. Yen positions are not yet in historical positions either. Net futures & options positions are shown below:

Canadian dollar longs likely to capitulate, yen shorts not in extreme territory today

10-28-2017 CFTC positions
Source: CFTC COT Report (October 24, 2017)

 

All in all, going long CAD/JPY looks compelling given the prospect of accelerating inflation. The currency pair did very well the last time growth and inflation were accelerating in tandem (November 2016), and this phenomenon looks likely again in Q4 2017.

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