US two-year Treasury yields are now trading around 100bp below the upper end of the Fed funds target – that is a historically deep discount and is typically seen before the US enters a recession. That discount can correct when the Fed brings the policy rate lower.
USD/JPY should again prove the key FX vehicle to express views on a US recession. Here Japan’s large net foreign asset position after decades of current account surpluses leaves the yen well insulated in an environment of deleveraging – a likely outcome were financial stability risks to re-materialise.
The forward market still prices 10-year JGB yields at 0.50/55% over the next six months, and presumably, these would trade much higher and the yen much stronger should the BoJ stop targeting the 10-year JGB maturity.
The FX options market currently prices a 31% chance that USD/JPY trades at 120 at or before the end of this year. We think the chances are higher (120 is our year-end forecast) and that USD/JPY will again prove the best vehicle to hedge a US recession.- ING FX Strategy
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