Forex: Dollar Eases Back From 6-Month High As FX Volatility Cools

With the US capital markets offline for the Martin Luther King, Jr holiday; speculative appetites were curbed Monday. For the currency market, this restraint led the FX Volatility Index to drop back from its four month high – and notably at the fastest clip since news of the last-minute Fiscal Cliff save back on January 2.

For the world’s reserve currency, the US dollar, the reduced tension would curb appetites for an ultimate safe haven. The Dow Jones FXCM Dollar Index (ticker = USDollar) responded with a modest retreat from the six-month high posted on Friday’s close 10,140. Yet, the modest pullback was hardly indicative of capitulation. And so, the positive correlation between dollar and S&P 500 lingers.

For speculative developments through the opening session of the trading week, there were a few developments on the Euro financial crisis and Japanese stimulus regime to give the US currency some indirect perspective; but there were no notable moves aside for USDJPY. FX traders are awaiting a resolute fundamental catalyst. Perhaps the BoJ decision, Apple earnings or House vote to raise the debt limit for three months.

Japanese Yen: What to Expect from the BoJ and USD/JPY
There is little debating the claim that the Japanese yen is the most oversold currency – perhaps even the most oversold asset – in the market. After 10 consecutive weeks of concerted rally (matching the longest consecutive bull market on records of floating exchange rates), the USD/JPY finds itself well over 1,000 pips higher without a meaningful correction to draw fresh capital in from dedicated investors – versus short-term speculative interests.

There is an argument to be made that this benchmark pair and the other yen crosses were long overdue for a meaningful advance to rebalance prevailing exchange rates to market potential. But what makes this moment the proper one for that adjustment versus two years ago when moral hazard was directing capital into the arms of higher yielding assets and currency pairs? This time around, we have a common objective for speculators to target: expectations for the Bank of Japan (BoJ) to adopt a "competitive" stimulus policy.

Towards the beginning of the yen crosses’ now storybook rally back in the latter months of 2012, the climb began with explicit threats made by Liberal Democratic Party (LDP) opposition leader Shinzo Abe. The eventual replacement for the Prime Minister positioned vowed to do "whatever necessary" to drive the Japanese yen to revive inflation and encourage growth.

So far, he has introduced a 10.6 trillion stimulus package (two weeks ago); but his greatest influence comes through his vow to strong arm the BoJ to adopt stimulus efforts that match those in the US and eurozone. That said, Japan’s central bank has so far only increased its asset purchases – not introduced the open-ended effort that Abe has promised. So, to this point, the climb for the yen crosses has run on the assumption of a more provocative effort.

For a rally of 1,000 to 2,000 pips in the span of a few months, the expectations have to be set exceptionally high. For the BoJ’s Tuesday morning policy decision (attended by Economy Minister Amari), there is a common assumption that an "unlimited" stimulus program will be adopted and it will hold to regular purchases until a 2.0 percent inflation target is met. That is aggressive for a country that has suffered over two decades of deflation, but the kind of bold action that officials seem to have to resort to.

Simply "meeting expectations" may be difficult to do in this scenario. In an open-ended stimulus program, traders may expect the central bank will adopt monthly stimulus injections in a size that is similar to what the Federal Reserve has committed to ($85 Billion). If that is the case, the market may be expecting monthly purchases of JGBs and other assets of over 7.7 trillion yen. That is a considerable figure for the policy group to live up to.

Euro Little Moved after Euro-Area Ministers Discuss Greece, Cyprus, Bailouts
Euro-area Finance Minister met Monday to discuss the brush fires that are still smoldering in the region’s financial health. The reports from the meeting offered some positive news: approval of Greece’s next payout this month (€9.2 billion); a new EU Chairman in Dijsselbloem; and – most remarkable – rumor that officials would consider changes to Ireland and Portugal’s bailout repayments. However, we still have clear discord on a Cyprus bailout and other lingering risks. Up next we have the EU Finance Ministersmeeting and Euro-area investor confidence measures.

Australian Dollar Traders Look Ahead to 4Q CPI Data
Last week, we saw the impact that a well-placed economic indicator aimed at a fundamental nerve could accomplish when AUD/NZD responded to New Zealand’s 4Q CPI figures. And, it is worth noting that the RBNZ has been exceptionally resilient to changing its policy bearings. What will that mean for the Australian dollar considering we have 4Q Australian CPI figures due tomorrow and the market is actively speculating on further RBA cuts? The figure just recently returned to the 2.0 percent target in the 3Q. If we don’t see further progress, rate cut fears will likely increase.

British Pound: Prime Minister Cameron Schedules his EU Speech
Last week, pound traders were growing increasingly concerned that Prime Minister David Cameron was going to reflect on a cooling relationship between the UK an EU that could eventually lead to a withdrawal of the former from the latter. There is general consensus that such an outcome would hurt the UK far more than its counterpart region. We now have a new date for that speech: Wednesday, January 23.

Swiss Franc Fails to Set Higher High, First Step in a Turn?
Friday, EUR/CHF closed out the day in the red, but not before setting a new high well above the range high established between October to December of 2011. This morning, that decelerated pace wax further wrenched into a bearish development with the first back-to-back decline for the pair since January 4. A full reversal depends on the perception that a Euro-area crisis is regaining steam, but this hesitance sets the stage.