What The Markets Think About USD/JPY

USD/JPY may not have been the best or worst performing currency pair Monday but it received a large part of the market's attention. After dropping below 94 last month, the currency pair staged a dramatic recovery that has taken it within striking distance of 100. Between the Federal Reserve's plans to taper asset purchases and the Bank of Japan's aggressive Quantitative Easing program, a break of 100 is almost inevitable. However what investors are really wondering about is not if USD/JPY will take out 100 but whether it will reach a new four-year high above 103.74.

Based on the direction of monetary policy, we feel that USD/JPY should revisit its highs because the Federal Reserve is moving closer to ending Quantitative Easing while the Bank of Japan is still knee deep in implementing its $1.4 trillion Quantitative Easing program. For the markets, this means that the BoJ will keep a lid on JGB yields while the Fed policy will drive Treasury yields higher and the differential between U.S. and Japanese yields have been a leading driver of USD/JPY. However it goes beyond that, if U.S. yields continue to rise, Japanese companies will start to reduce their hedges as the cost to maintain these positions rise which is another factor that could drive USD/JPY back to its 2013 high. The Japanese economy is also improving which helped stabilize the Nikkei. If the Japanese index continues to rebound thanks to Japan's ultra easy monetary policy, it should benefit USD/JPY. Most importantly however, for USD/JPY to rise, the Fed needs to be right about the labor market. They lowered their unemployment rate forecast two weeks ago and investors will be watching closely for a validation of their optimistic outlook on Friday.

If the Fed gets it wrong (not just this week but in the months that follow) and their quest to taper ends up driving U.S. yields sharply higher and stocks sharply lower, any initial rally in USD/JPY could fade quickly as risk aversion takes over and investors start to unwind everything including their yen shorts -- we got a taste of that at the beginning of the June. Slower Chinese growth also poses a problem for the markets and U.S. policy. Based on the sharp rise in SHIBOR rates last month and the delayed response from the central bank, Chinese policymakers appear to have grown more tolerant of slower growth. In other words, the Fed is tapering at a time when the domestic and global recovery is on shaky ground and the risk is that it could backfire, leaving 103.74 as a significant top for USD/JPY.

So while we think USD/JPY should break 100 and will most likely hit 103 as well, there's enough risk for to be skeptical about whether new highs are achievable without a healthier and more broad based global recovery.

Short But Busy Week For The Dollar
Currencies and equities had a strong start to a shortened but busy trading week. With U.S. markets closed on Thursday for the July-4 holiday, volume in the financial markets will start to decline Wednesday afternoon and remain thin through Friday. Typically this means tighter ranges and lower volatility for currencies but this year with an ECB meeting and the non-farm payrolls report scheduled for release, the decline in volume could lead to greater volatility. In fact this week last year, EUR/USD dropped more than 400 pips to its lowest level in two years. The focus however is on the dollar, which surged to new highs against many of the major currencies last week. Investors are still divided on when the Fed will taper -- September or December and the monthly labor market numbers will play a big role in shaping expectations for the currency and bond markets. The rally in USD/JPY Monday suggests that investors are positioning for a good jobs number after the Federal Reserve lowered its unemployment forecasts two weeks ago. We don't need much -- a small increase in non-farm payrolls and a steady unemployment rate or a small slowdown in job growth accompanied by a drop in the unemployment rate is all that bond investors need to drive yields to new highs. This is important for FX traders since they have been taking their cue from Treasury yields. Stronger than expected manufacturing activity in the U.S. helped to extend the gains in USD/JPY. The ISM manufacturing index rose from 49 to 50.9 in June, returning the sector to expansion after one month of contraction. The details of the report was mixed. While prices, new orders, production and new export orders increased, the backlog and more importantly employment component of the report declined. In fact, employment conditions in the manufacturing sector contracted for the first time since September 2009. Underlying weakness prevented USD/JPY from immediately shooting higher to 100 but with time, we still expect this level to be hit. U.S. factory orders and the IBD/TIPP economic optimism index are the only pieces of U.S. data scheduled for release Tuesday. Since these are not big market movers for USD/JPY, we expect the currency pair to hold onto its gains.

EUR: Stronger Data Keeps 1.30 Intact
An upward revision to the euro-zone's PMI manufacturing report kept the EUR/USD above 1.30. The currency pair tested this level every day for the last four trading days and so far this key technical level is holding firm. As usual at key round numbers such as 1.30, there can be a significant amount of orders that are protected around that level. Nonetheless the upward revision of the index from 48.7 to 48.8 is encouraging. While we were a bit worried about the downward revision to the German PMI manufacturing index, the improvements seen in France and Spain are constructive. As our colleague Boris Schlossberg noted, Spain's PMI index rose above the key 50 boom/bust mark for the first time in nearly two years while Italian PMI improved as well hitting 49.1 from 47.3 the month prior. "The news out of Europe was the first tangible proof of improving economic activity in the periphery economies and indicates that the region may be finally starting to turn towards growth as the summer progresses."At this stage, we may not see the EUR/USD break below 1.30 before ECB President Draghi's press conference on Thursday.

GBP: Shrugs Off Stronger Manufacturing Data
The British pound weakened against the U.S. dollar and euro despite better than expected economic data. The UK's manufacturing PMI index rose to its highest level in more than two years in June according to Markit Economics and Chartered Institute of Purchasing and Supply. Markit Economics said, "New orders at manufacturers rose for a fourth month in June, while input costs fell for a third month. Textiles, clothing, food and drinks categories led the pickup in manufacturing, though all categories covered by the survey showed improvement." Markit also noted that strength in production hints of 0.5% GDP growth in the second quarter, up from 0.3% in the first quarter. The Bank of England also revealed that mortgage approvals accelerated more than forecast adding to signs that the economy is recovering. Approvals rose to the highest since 2009. Number of loans approved was 58.2K in May, up from 54.4K the previous month. Former Bank of Canada Governor and now Bank of England Governor Mark Carney started his post at the central bank Monday. Carney will have his first meeting as BoE governor on July 3-4 and there is very little chance that any changes will be made. Former BoE deputy governor John Gieve said in an interview Monday said that Carney faces a challenge in advocating for more stimulus since Mervyn King failed to deliver in the past. Gieve said, "This is quite hard as a majority has voted against an extra boost for several months in a row and the news is a little bit better. He's got a big persuasive job if he wants to change their views today."

AUD: What To Expect From RBA
The Australian, New Zealand and Canadian dollars rebounded strongly against the greenback Monday thanks to an improvement in risk appetite and rise in commodity prices -- oil and gold rose more than 1.4% in value. The Reserve Bank of Australia was scheduled to meet Monday night and, despite the improvement in manufacturing conditions, we believe the central bank will maintain its bias to ease. The problem is China. Chinese manufacturing activity slowed to almost a halt in the month of June and with export prices moving lower, the RBA will be reluctant to remove their one source of support -- its weaker currency. We suspect that the central bank realizes that short Australian dollar positions are at record highs. If they sound overly optimistic, those could be squeezed out, driving the AUD sharply higher. Last night we learned that manufacturing activity in Australia improved last month with the PMI index rising to 49.6 from 43.8 in June. The index improved primarily on the back of a rise in new orders and supplier deliveries. AiG said, "The unexpected lift in the Australian PMI is a welcome, though tentative, sign that manufacturers' efforts to fight back against the severe pressures facing the industry are beginning to pay off." AiG also said, "Exports continue to struggle, with the exports sub-index only partially recovering from its recent record lows. At just 30.3 points, the exports sub-index continues to signal extremely tough exporting conditions, despite the fall in the Australian dollar."

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.