MUFG Recommends Short EUR/JPY Amid French Bond Stress and BoJ Tightening

What happened

MUFG, one of Japan's largest banks, has recommended a new short position in the EUR/JPY currency pair, with an entry at 177.50, a target of 172.00, and a stop-loss at 181.50. The recommendation is based on the expectation that diverging monetary policies from the European Central Bank (ECB) and the Bank of Japan (BoJ), coupled with increased stress in the Eurozone bond market, will lead to a depreciation of the euro against the yen.

The bank highlights that front-end yields in the euro area are falling as markets pare back ECB hike bets. This is partly due to the widening spread between French and German bond yields, which has tightened financial conditions in the region. ECB President Christine Lagarde has already indicated that higher long-term yields could slow growth and reduce inflation pass-through more than projected, lessening the urgency for aggressive hikes. Pricing for ECB hikes by mid-2027 has already fallen around 30 basis points from its peak.

In contrast, MUFG expects the BoJ to deliver another rate hike before year-end, though likely not this month, which would narrow yield differentials with the euro area. Furthermore, the yen tends to benefit from an increase in risk aversion, which can trigger the unwinding of yen-funded carry trades, as observed in the week to October 2, when the yen and Swiss franc were the best-performing G10 currencies.

Why it matters

MUFG's recommendation reflects a market view that points to increasing fragmentation within the euro area and a shift in Japan's monetary policy stance. The stress in French bonds, with spreads against German bonds widening more than expected, signals political and fiscal risks that affect the perceived risk of the single currency. This situation leads to a tightening of financial conditions in the euro area, which, in turn, may reduce the need for the ECB to aggressively raise interest rates.

Simultaneously, the expectation of a more hawkish BoJ marks a potential shift from decades of ultra-loose monetary policy in Japan. The combination of a potentially less hike-prone ECB and a more tightening-prone BoJ creates an interest rate differential that favors the yen. Moreover, in times of increased global volatility, the yen is traditionally seen as a safe-haven asset, benefiting from the unwinding of carry trades.

Market impact

• Interest Rates and Bonds: Front-end yields in the euro area are likely to fall, reflecting reduced ECB hike expectations. The spread between French and German bond yields may continue to widen, indicating a higher perceived risk for French debt. In Japan, yields may rise slightly with the expectation of BoJ tightening.
• Dollar and FX: The EUR/JPY pair is likely to fall, with the euro depreciating against the yen. Global risk aversion may strengthen the yen as a safe haven. The US dollar might benefit from a risk-off scenario, but the primary focus is on the EUR/JPY dynamic.
• Equities: European stock markets, especially French ones, may face negative pressure due to increased risk perception and tighter financial conditions. An increase in global risk aversion tends to be negative for equities in general.
• Commodities: Increased risk aversion could lead to demand for safe-haven assets and potentially pressure commodity prices, although the direct impact is less clear. An energy price shock, such as from the Iran war, could add to Japan's import bill, which might temper the yen's gains if oil spikes again.
• Brazil: Increased global risk aversion and yen appreciation may lead to a flight to safety, which generally tends to be negative for emerging market currencies like the real. However, the direct impact on Brazil is secondary to this EUR/JPY dynamic.

What to watch

Investors should monitor the following key points:

• ECB data and statements: Any indications regarding the future stance of ECB monetary policy, especially concerning interest rates and the assessment of fragmentation risks in the euro area.
• BoJ decisions: The next BoJ meeting and any signals of a rate hike or a change in its yield curve control policy.
• European bond market: The evolution of French bond spreads relative to German bonds. A stabilization or narrowing of these spreads could invalidate MUFG's thesis.
• Global volatility: Levels of volatility in financial markets, which can influence carry trade dynamics and demand for safe-haven assets.

Scenarios

Base Case: French bond stress persists, leading the ECB to adopt a less hawkish stance. The BoJ delivers a rate hike before year-end. Global risk aversion increases, strengthening the yen and pushing EUR/JPY closer to the 172.00 target. Risk Scenario: European bond markets stabilize, with French spreads narrowing, perhaps due to signs that forced OAT selling is exhausting or that the French budget passes smoothly. This could spark a sharp short-covering rally in the euro, pushing EUR/JPY above the 181.50 stop-loss level.

Original source: ForexLive (InvestingLive). For information only, not investment advice.