Euro steadies against Japanese Yen as markets weigh ECB, BoJ rate hikes

• EUR/JPY trades around 185.65 on Monday, virtually unchanged on the day.
• Japan’s core inflation accelerates in July, reinforcing expectations of higher interest rates in Japan.
• The interest rate gap with other major economies and concerns over Japan’s fiscal position continue to limit the Japanese Yen’s appreciation.

EUR/JPY trades around 185.70 on Monday at the time of writing, virtually unchanged on the day. The Japanese Yen (JPY) draws some support from firmer inflation data in Japan published on Friday, although its appreciation potential remains limited by the wide interest rate differential between Japan and other major economies, as well as concerns over the country’s fiscal position.

Japan’s National Consumer Price Index (CPI) rose 1.9% YoY in July, up from 1.6% in June and reaching its fastest pace so far this year. Core inflation, which excludes fresh food, accelerated to 1.8% YoY from 1.6% previously.

The data reinforces expectations of further monetary tightening by the Bank of Japan (BoJ). According to Bloomberg, markets are pricing in around an 82% chance of a September rate hike, up sharply from just 23% immediately before the July monetary policy meeting. This shift in expectations provides some support to the Japanese Yen and limits the upside potential for EUR/JPY.

Attention now turns to a speech by BoJ Deputy Governor Ryozo Himino on Thursday. Comments pointing to a relatively rapid continuation of monetary policy normalization could reinforce rate hike expectations and provide further support to the Japanese currency.

However, several factors continue to curb the Japanese Yen’s appreciation. Despite expectations of faster monetary tightening, borrowing costs in Japan remain significantly lower than in other major economies. This wide interest rate differential continues to encourage carry trades, in which investors borrow in a low-yielding currency to invest in higher-yielding assets.

Concerns over Japan’s deteriorating fiscal position also remain a headwind for the JPY. In addition, risks to the Japanese economy stemming from the prolonged conflict in the Middle East and disruptions in the Strait of Hormuz weigh on the currency. These factors partially offset the support from expectations of BoJ rate hikes and help keep JPY balanced.

At the same time, expectations of tighter monetary policy from the European Central Bank (ECB) provide support to the Euro (EUR), limiting the downside in EUR/JPY. Markets are pricing in a 95% chance of an ECB interest rate hike in September, according to the ECB Watch tool. The prospect of higher borrowing costs in the Eurozone helps underpin the single currency and partly offsets the support that rising BoJ rate hike expectations provide to the Japanese Yen.

Deutsche Bank sees localized energy shocks keeping ECB on track for one last September hike

Strategists at Deutsche Bank argue that the ECB may be overinterpreting recent goods price dynamics, noting that the central bank had viewed the latest acceleration as evidence of indirect effects from the oil shock broadening out. In their view, the July jump in core goods inflation to "0.95% y/y was largely a one-off 5.2% m/m spike in German medicine prices due to regulatory changes." Stripping out this distortion, they say "momentum is softer"; they highlight that "airfares even surprised to the downside, showing slow fuel cost pass-through," while "high-energy-sensitive indices remain below May levels and the Inflation Shock Momentum index ticked down, indicating localized one-off shocks rather than a generalized broadening of energy prices."

Against that backdrop, Deutsche Bank contends that "without clear evidence of broad-based second-round effects, a hike past the 2.50% neutral upper bound is unlikely," reiterating that "we continue to expect a final 25bps ECB hike in September to a 2.50% terminal rate." They add that "robust bank lending would signal to the ECB that the domestic economy is resilient, and suggest there is scope for the ECB to hike further if they need to," making credit dynamics a key variable for any extension of the tightening cycle beyond September.

Looking ahead to the policy debate, Deutsche Bank notes that "the ECB will release the accounts of their July meeting next Thursday." With "a September hike [feeling] more or less a done deal (as we noted in our reaction note)," they point out that "we have heard little from the Governing Council over the summer break, so the accounts might get a bit more weight than they usually do."