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Over the last few months, the foreign exchange market has been more sensitive to Central bank policy measures than at any other time in decades. However, the problem for the Central banks is that the FX market has largely not responded in the direction that they have intended. This is best illustrated by this year’s monetary transmission efforts by the Bank of Japan (BoJ).

The BoJ has, from a percentage of GDP basis, easily been the most aggressive of the all the G-7 central banks with the BoJ’s balance sheet reaching JPY 450 trillion early last month. Despite this aggressive easing, the BoJ has not come close to its three main policy goals of increasing consumer demand, kick-starting GDP growth and pushing domestic inflation back above 2%.

This impossible trinity of inflation, consumption and GDP growth took another hit today when the BoJ failed to satisfy the market with its most recent addition to the long running QQE policy. The Bank of Japan expanded its purchases of exchange-traded funds and doubled the size of a U.S. dollar lending program, while refraining from boosting the pace of government-bond purchases that have formed the main part of its monetary stimulus.

The central bank kept its annual target for expanding the monetary base at 80 trillion yen ($779 billion), done mainly through an equivalent increase in government bond holdings. It also left untouched the minus 0.1 % rate for a portion of commercial banks’ reserves. A dollar-lending program was expanded to $24 billion.

The last week of July has a full schedule of first tier data releases and market events. These include the FOMC and BoJ meetings, the German IFO survey, Australian inflation data and GDP reports from both the USA and UK. In general, we believe the BoJ meeting will have more market impact than the FOMC meeting, the US GDP data could surprise to the upside and a weaker Aussie inflation report may not convince the RBA that an August rate cut is the appropriate course of action. 

However, we believe one of the most important data points for the week will be when the European Banking Authority stress tests are released after the NY close on Friday.

The financial markets have recently focused on Italian banks and their swelling non-performing loan book but there is an acute risk that other Euro-Zone banks, including large German, Austrian and French banks, will need to raise capital as well. It’s worth noting that the MSCI European Bank Index lost almost 25% of it’s value after the UK referendum, including a 28% drop in the shares of Deutsche Bank.

From a FX point of view, the main significance is that the correlation between the MSCI EZ Bank Index and the EURO currency has grown. Market statistics show that the running 60-day correlation between the value of EUR and the Index now stands at a positive 50%. This is the strongest reading on the 60-day correlation since Q1 2014 and adds to the growing negative fundamentals for the single currency.