How Much Further Can USD/JPY Fall?

Currencies were front and center Tuesday courtesy of the big moves in the Japanese Yen. We have not seen a decline as deep as the one in Tuesday's USD/JPY since repatriation drove the Yen sharply higher after the March 2011 earthquake and tsunami. If you were trading currencies at the time, you may remember that shortly after USD/JPY dropped more than 4% in one day, the G7 responded with coordinated intervention to weaken the Yen. Unfortunately traders can't expect the G7 to step in this time around to halt the rise in the yen because the only reason why they agreed to do so in 2011 was because they wanted to provide global support to Japan after the earthquake. This time, the Japanese caused the Yen to rise by denying Japan additional stimulus. In other words, they only have themselves to blame. So if we don't get any support from the G7, then how much further can USD/JPY slide? In the past 24 hours, the currency pair fell 3% and is now close to 7% off its May high.

There is no question that from a technical perspective, the downward momentum in USD/JPY is very strong with 95 being the key support level for the currency pair. This level continues to hold for the time being but if it is broken, there is very little support until 0.9150, the 38.2% Fibonacci retracement of the 2008 to 2011 rally that took the pair from a low of 60 cents to a high above 1.10. Currently there's very little reason to pick a bottom in any of the Yen pairs and for those banking on 95 to hold in USD/JPY, stops are absolutely necessary and even then could be subject to significant slippage by brokers if 95 is broken and the currency falls sharply.

From a fundamental perspective, without the Japanese publicly criticizing the moves in the Yen or unambiguously positive U.S. data that prompts a signal from the Fed that they want to pare asset purchases, the currency could continue to rise, driving USD/JPY to fresh lows. Having just made a monetary policy decision to do nothing, we are skeptical about the chance of a U-turn by Japanese officials but the markets have been extremely volatile and as a new BoJ Governor, Kuroda may learn the dire consequences of overconfidence.

The Bank of Japan's decision last night to deny Japan of additional stimulus triggered a wave of deleveraging that has driven currency and equities sharply lower. By refusing to increase stimulus in the face of rising volatility in the Nikkei, JGB and the Yen, the BoJ is testing its luck with the market. Based on the price action over the last 24 hours, investors are clearly not happy with the central bank's decision and if the Yen continues to rise and equities and bonds continue to fall, the BoJ will be forced to act. Not only did the BoJ fail to increase the frequency of JGB purchases but they also did not extend the maximum duration of its funds supply operation from one-to-two years, which was the minimum the market anticipated. This was a conscious decision on the part of the BoJ to ignore the turbulence in the market. BoJ Governor Kuroda confidently said that weekly asset purchases would be sufficient to lower volatility over time. With monetary and fiscal policy proving to be less aggressive than Prime Minister Abe once promised, investors have been sorely disappointment and as a result we could see further gains in the Japanese Yen and additional deleveraging in the Yen crosses before the dust settles.

USD: BoJ Action Heightens Volatility In US Markets
The lack of U.S. data in the front of the week has not translated into a lack of volatility for the U.S. dollar or the FX market in general. The dollar traded lower against all of the major currencies with the exception of the AUD and NZD. Even against the commodity currencies, the dollar is well off its highs. U.S. markets were extremely volatile with stocks oscillating in and out of positive territory. U.S. 10-year bond yields also rose to a one-year high of 2.29% before settling down a few basis points. With no U.S. data on the calendar, the volatility in U.S. markets were caused entirely by the risk aversion. In fact, Tuesday was perfect example of how the actions of the Japanese can have global ramifications. We have long warned that the steep losses in the Nikkei point to a potential correction in U.S. stocks and while the sell-off in the S&P 500 was still modest, U.S. markets may have a very tough time recapturing their losses if the Nikkei fails to recover. Investors around the world have been watching the volatility in Japanese markets for the past month and selling their stocks and bonds slowly. By denying Japan additional stimulus, the Bank of Japan is effectively denying the world of much needed support for one of its most important economies. They are also sending a strong message to the market that central banks won't be held hostage by market volatility and not to expect the spigots to be opened every time rallies are reversed. Once again, we fear that the BoJ is playing with fire and will end up being burned badly. For investors, the recent decisions in Japan are and could continue to have global ramifications. With no U.S. economic reports scheduled for release Wednesday, the dollar will continue to take its cue from the market's appetite for Yen.

EUR Hits Fresh 3-Month Highs
The euro hit a fresh three-month high against the U.S. dollar despite dovish comments from ECB officials. According to Asmussen, the central bank is prepared to purchase unlimited government bonds via Outright Monetary Transactions and will sell bonds purchased once the Monetary Transmission mechanism is unblocked. While there is no immediate need to activate OMT, the mere discussion of it suggests that European policymakers maintain a dovish bias. ECB member Praet also felt that inflation is "on the low side" which gives the central bank the flexibility to keep monetary policy easy. There were no major euro-zone economic reports released Tuesday but the German Constitutional Court began its hearing on the legality of OMT. The ECB has the support of the German Finance Minister who argued that the court had no jurisdiction over the program and credited OMT for saving the euro zone from a messy sovereign debt crisis. Unfortunately the head of the Bundesbank feels that OMT threatens Germany's ability to manage its own monetary policy. While there are strong supporters and critics of OMT, we feel that in the end the benefit of making OMT available have been clear and to reject its legality would mean re-introducing a fresh source of uncertainty for the financial markets. German and French consumer prices are scheduled for release Wednesday and for the most part, these reports are expected to show that inflationary pressures remain low across the region. Meanwhile the Swiss Franc soared against the euro and U.S. dollar after the State Secretariat for Economics upgraded the country's 2013 GDP forecast to 1.4% from 1.3%. Consumer prices are also expected to drop 0.1% this year compared to a prior forecast of 0.1% growth.

NZD: What Will RBNZ Say About The Currency?
Our colleague Boris Schlossberg described it best when he said the AUD was destroyed in overnight trade and while the AUD and NZD extended their losses against the USD Tuesday, both currencies ended the North American trading sessions well off their lows. In fact, some technicians may even argue that the long wick in AUD/USD and NZD/USD point to a potential reversal or in this case, a stronger recovery for both pairs. Given how grossly oversold these pairs are, we wouldn't be surprised if there is a relief rally but there's no specific catalyst for one over the next 24 hours. The sell-off in both currency pairs was driven entirely by risk aversion and deleveraging as economic data was mixed. While Australian home loans grew at a slower pace in April, business conditions improved and confidence held steady after being revised higher in May. Australian consumer confidence numbers were due for release Tuesday evening followed by the RBNZ rate decision Wednesday afternoon in NY, Thursday morning in New Zealand. The Reserve Bank is not expected to change interest rates but their comments about the New Zealand dollar could have a significant impact on the currency. When we last heard from the central bank, the RBNZ expressed their concerns about the NZD, which had risen to a four-year high against the AUD. There's been very relief since then and so there is a very good chance they will harden their warning about intervention which could extend the slide in the NZD/USD and finally stop AUD/NZD from falling.

GBP: Will Jobs Report Drive Sterling Even Higher?
The British Pound continued to rise against the U.S. dollar and euro after industrial production rose by 0.1%. The report released by the Office for National Statistics revealed that industrial production gained 0.8 in the past three months, which was the largest rise since July 2010. UK manufacturing fell 0.2% but this decline was in line with economist expectations. However, in the past three months manufacturing rose 0.5%, which was the most since September of last year. A report by NIESR estimates that GDP will rise by 0.6% compared with 0.1% in April. With the Bank of England holding off on any further easing earlier this month due to signs of recovery in the economy and the British Chambers of Commerce raising its growth forecast last month, the outlook for the U.K. is bright. Labor market numbers will be released Wednesday and we believe jobless claims will continue to fall. Last month, the service sector saw its strongest growth in three months while the manufacturing sector enjoyed its first month of job growth in four. Good data would compound the gains in the currency.

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