Why The USD/JPY Should Be Lower

With only second tier U.S. data on the calendar, the dollar is trading higher against most of the major currencies but its gains are small because today's move represents nothing more than a relief rally after steep losses. Despite a solid 3.7% increase in durable goods orders, excluding a sharp rise in aircraft demand, durable goods actually fell 0.1%, making the overall release a net drag on the dollar. A revision to the University of Michigan's consumer confidence number is due later this morning but we don't expect the report to have a dramatic impact on currencies.

Big Nikkei Drop
With that in mind however, USD/JPY should be trading much lower this morning. The Nikkei dropped 2.75% overnight, which was the largest one-day decline since August. An unexpected rise in consumer prices contributed to the weakness but the primary reason why Japanese stocks performed so poorly is because of the continued rise in Chinese rates. Higher interest rates in China has the same restrictive impact on the economy as higher interest rates in the U.S. and if yields on T-bills rose as quickly as short term instruments in China, the S&P 500 would probably be below 1700 and not above 1750. The one-week SHIBOR rate rose 21bp overnight to 4.89% while the one-month rate rose 102bp to 6.422%, taking the yield on both instruments to their highest level since July. Stock markets across Asia sold sharply in response but there has been little reaction in Europe and the U.S.

Nonetheless, the following chart of USD/JPY vs. Nikkei shows how correlated these two instruments have been over the past three years. While past performance is never an indicative of future results, judging from the charts, USD/JPY should be trading closer to its three-month lows at 96.
USD/JPY vs. The Nikkei" width="715" height="468">
The 10-Year Yield Factor
The relationship between USD/JPY and Japanese stocks is not the only factor pressuring the currency pair lower. Take a look at the following chart of USD/JPY vs. 10-Year Treasury yields. With yields at three-month lows, it also suggests that USD/JPY should be weaker and if yields continue to fall due to weaker U.S. data or more talk of tapering next year, USD/JPY could under additional selling pressure.
USD/JPY vs. 10-Year Yields" width="708" height="473">
However, if for any reason the Nikkei or U.S. yields start to recover, this same correlation could fuel a stronger rally in USD/JPY.

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