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Pound-Yen's Yield Driven Rally Hinged On Central Bank Trifecta 

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The Pound-to-Yen exchange rate little changed On Wednesday after having stalled near to three-year highs earlier this week, leaving the British currency's rally and GBP/JPY's outlook hinged on whether central banks are able to deliver a trifecta of supportive policy announcements ahead of the weekend. 

Investors' responses overnight and into Thursday to the March Federal Reserve (Fed) decision are the first potential pitfalls for the Pound-to-Yen exchange rate because any subsequent tamping down of upward pressure on American bond yields would risk profit-taking that strengthens the Japanese Yen. 

Declines in U.S. bond yields, which reached new pandemic highs on Wednesday ahead of an eagerly anticipated monetary policy update from the Fed, could lead Japanese investors to the abandon the recently charged up U.S. Dollar resulting in a downward correction for USD/JPY. 

That would have bearish consequences for the Pound-to-Yen exchange rate, which always closely reflects an amalgamation of price moves USD/JPY and GBP/USD. GBP/JPY would fall with USD/JPY unless GBP/USD was able rally enough to offset strength in the Yen and weakness in the Dollar. 

"If Powell does nothing, we could perhaps be on the verge of a 2013-style Taper Tantrum. That would send Godzilla-sized shockwaves through markets everywhere," says Michael Every, a global strategist at Rabobank

Above: USD/JPY shown at 4-hour intervals alongside Pound-to-Yen rate (green line). 

Investors will on Wednesday and overnight into Thursday be scrutinising the response of the Federal Reserve to a recently improved U.S. economic outlook that has seen investors wagering the bank will curtail its quantitative easing programme and lift interest rates as soon as 2023.

This has doubtless played a role in almost doubling some U.S. government bond yields this year, which have been a draw for investors including those from Japan, who've driven USD/JPY 6.1% higher in 2021 and contributed substantially to the simultaneous 7.37% rally by the Pound-to-Yen rate. 

"Beyond the Fed we are also heading towards the long awaited BoJ policy review. Thin liquidity ahead of the policy decisions is likely to see USD/JPY remain within a 108.65-109.40 range," says Jeremy Stretch, head of FX strategy at CIBC Capital Markets

The 10-year yield had been around 1.40% when in early March Powell told Congress the Fed isn't worried about increases in borrowing costs, before suggesting to lawmakers that the latter merely reflect an economy in recovery mode and a market becoming confident of a robust outlook. 

Above: USD/JPY shown at weekly intervals alongside 10-year U.S. government bond yield (red line). 

But the 10-year yield rose above 1.66% on Wednesday after having entered the year barely above 0.80%, and despite that Fed Chairman Jerome Powell and others have previously said they're comfortable with this, investors are looking to the bank for a signal that it's still comfortable. 

"The very weak Japanese yen of late has been driven by a rise in bond yields globally, widening the spread between those and the lower yielding long end of the Japanese curve, which the market suspects the Bank of Japan is not willing to allow to rise," says John Hardy, head of FX strategy at Saxo Bank. "Friday’s BoJ meeting will deliver the conclusions of a policy review that should make clearer the bank’s position on how much it wants to control yields."

Wednesday's Fed event comes ahead of Friday's Bank of Japan (BoJ) policy decision, which is widely perceived as less of an upside risk to the Yen, although and in light of the already-significant losses seen by the Yen this year the BoJ risk may now be more balanced than many observers give credit for. 

The BoJ said in December it will "conduct an assessment for further effective and sustainable monetary easing," citing an economy and inflation pressures that are "projected to remain under downward pressure for a prolonged period." 

Above: Pound-to-Yen rate shown at weekly intervals alongside 10-year British government bond yield (red line). 

The outcome of the study will be announced in the early hours of Friday for those in the UK, but if Governor Haruhiko Kuroda turns up empty handed the Yen could strengthen and GBP/JPY fall. 

"USD/JPY remains resilient above 109.00. Bank of Japan (BoJ) Governor Kuroda reiterated it was not necessary to change the yield curve control framework (+/‑20bps around the 0% 10‑year JGB yield target). The BoJ will unveil the findings of its policy framework assessment on Friday," says Elias Haddad, a senior FX strategist at Commonwealth Bank of Australia

The BoJ said last year that any new policy tool would be separate and distinct from the "QQE with Yield Curve Control" operation it has relied on to date, which it judged to be working well. Governor Kuroda repeated those sentiments earlier this week. There is a not-insignificant risk that the BoJ's multi-month contemplation of what more it could do to support Japan's economy was a thinly disguised warning that it would act this year to weaken the Japanese Yen if the currency market didn't take a hint in the interim.

Last year's Dollar depreciation has since fizzled somewhat but previously lifted the Yen against many currencies, in the process making imports into Japan cheaper while threatening to further reduce already-inadequate inflation and growth pressures. But with the Yen having fallen heavily against every other major currency this year, Governor Kuroda is now in a position where he could risk a short-term bout of strength in the Yen without pushing further from view the BoJ's long-lost 2% inflation target. 

Above: Pound-to-Yen rate shown at monthly intervals alongside USD/JPY (blue line). 

"With the Bank of England (BoE) emerging as one of the most hawkish central banks in the G7 in 2021, we've been fielding a number of question on whether the BoE could potentially hike before the Fed. Our own view is that the bar for the BoE to out-hawk the Fed – at this stage – is a high one," says Sanjay Raja, an economist at Deutsche Bank. "While US and UK inflation expectations remain well anchored, the risk that inflation could sustainably overshoot is perhaps less so in the UK."

Intermittently of Wednesday's Fed decision and Governor Kuroda's appearance on Friday, Sterling and GBP/JPY must first doth caps to the Bank of England (BoE), which announces its March decision at 12:00 Thursday. Bond and currency markets will also be looking to see here what, if any, response is given to rising British bond yields.

The UK is as fortunate as the U.S. in having one of the world's fastest vaccine rollouts and what was briefly the world's largest dose of public financial support for companies and households, both of which have led economists to increasingly suggest the country could see one of the strongest recoveries this year and which has gone some way toward explaining the rally in British bond yields that may also have played a role in lifting GBP/JPY. 

This, and the UK's lesser struggle generating inflation has, since the BoE's February decision, seen financial markets abandon wagers the Bank would cut interest rates below zero this year in favour of pricing-in more than two rate rises over the next two years. Deutsche Bank says that's probably too much to ask of the BoE, although if the Fed doesn't topple the Dollar beforehand, the BoE would need to bring the British yield rally to an end this week to unravel GBP/JPY. Beyond there, Sterling's rally against the Yen will be at the liesure of Governor Kuroda and colleagues at the BoJ.

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