The Dollar-Yen Pullback Should Be Temporary

It has been an extremely volatile day in the financial markets with a complete U-turn in currencies and equities. The U.S. dollar and U.S. stocks had been trading well for most of the NY session but in the last two hours of trading, things went south very quickly. The sell-off in the financial markets coincided with the release of the FOMC minutes but what was interesting above the move was how traders had a very different reaction to Bernanke's testimony and the Fed minutes even though the underlying implications were the same. Early in the day, the U.S. dollar and U.S. equities soared after Bernanke said the Fed could cut the pace of asset purchases in the next few meetings. Investors focused on his optimism even though a reduction in asset purchases meant that the central bank is taking the punchbowl away, which should be negative for equities. However when the Fed minutes confirmed that the central bank is having a lively discussion about slowing asset purchases, the S&P 500 gave back all of its to end the day down 0.83%. The dollar also followed lower even though fewer asset purchases should be positive for the greenback.

The only market that had a consistent and logical reaction was Treasuries. Ten year Treasury yields rose above 2% for the first time in two months and this suggests that the pullback in USD/JPY should be temporary. According to the Fed minutes, there's still a wide division within the central bank with some members calling for the Fed to dial back QE as early as June. However the majority still believes that more progress is needed before changes can be made. This is consistent with the message from Bernanke and Fed President Dudley both of whom suggested that a reduction in bond purchases are a few months away. USD/JPY rose to a 4.5-year high of 103.73 Wednesday and as long as U.S. Treasury yields continue to increase, we expect the currency pair to make new highs.

The reason why September is a possible target month for asset purchase reductions is because it fits right into Dudley's timing of three-to-four months and puts us into a next meeting with a quarterly press conference from the Fed Chairman. This is a major change in policy and Bernanke will want to manage the market's future expectations -- the press conference gives him the perfect opportunity to do so. While the Fed Chairman is worried about the high level of unemployment and the "substantial drag" that fiscal restraint puts on 2013 growth, inflation is low and the current level of interest rates is adding to employment, wealth and the housing market. He spent a lot of time talking about an exit strategy, saying that winding down QE will be the first part of that plan and that allowing securities to roll off could be part of their strategy. His concerns about frothiness and bubbles also suggest that they are prepping for an exit even though any movement will be in baby steps. Meanwhile jobless claims, the house price index and new home sales are scheduled for release Thursday.

Will PMIs And Draghi Drive EUR Below 1.28?
The euro along with all major currencies fell aggressively against the U.S. dollar Wednesday after Federal Reserve Chairman Ben Bernanke said they could cut the pace of asset purchases in the next few meetings. Despite the rise in U.S. bond yields and signs of a slower recovery, Bernanke sent a very clear message to the market that the Fed is getting close to dialing back their bond buying program. However even with the rally in the greenback, the EUR/USD continues to hold above 1.28, a level that has supported the currency pair since the beginning of April. Whether this level continues to hold will hinge on Thursday's PMI reports and speech from ECB President Draghi. A large part of the recent sell-off in the euro was caused by concerns about the health of the euro-zone economy -- because the region is in recession, the ECB felt the need to ease monetary policy. If Thursday's euro-zone PMI numbers show improvement, then the hope for a brighter Thursday will make 1.28 a near term bottom. Given the rise in equities, the slide in the euro and the rebound in industrial production and factory orders, we expect to see some improvements in the region's economy. Yet the data could still surprise to the downside and if it does, the EUR/USD could break below 1.28. How much of a recovery if at all the euro will get to enjoy will depend on what ECB President Draghi says in his speech Thursday on "The Future of Europe in the Global Economy." In the interest of preventing the euro from recovering sharply, we believe that Draghi will remind the market they are still thinking about negative interest rates and buying asset backed securities. Although the bar may be high, a weak euro helps the central bank's efforts to stimulate the economy and the central bank will look to hold onto any and all support they can get for the economy. A number of other euro-zone policymakers will also be speaking Thursday so keep your eyes on the newswires.

GBP: Crushed By Retail Sales And BoE Minutes
The British pound sold off aggressively against the euro and U.S. dollar following disappointing economic data and dovish BoE minutes. First quarter GDP numbers are expected Thursday and while the recent improvement in trade activity and rise in retail sales in the first three months of the year should boost growth, sterling may not see much benefit from a stronger number as investors overweight more recent data. Sterling hit a one-month low, Wednesday, after U.K. retail sales dropped 1.3% in the month of April. This pullback in spending took the market by complete surprise as economists were looking for a flat reading and the sticker shock of release should keep the currency weak. According to our colleague Boris Schlossberg, "This was the worst reading since April 2012 and was driven by a sharp drop in food store sales and weak sales of summer items due to bad weather conditions. Some of the decline may have been seasonal but the overall number suggests UK consumer demand remains weak and despite the recent spate of better than expected economic numbers, the UK economy remains vulnerable to further contraction. Little wonder then that the MPC minutes revealed a surprisingly dovish stance with three of the nine members continuing to vote for more QE. Outgoing Governor Mervyn King along with Miles and Fisher all voted for another 25B GBP QE arguing that the slack in the labor market and risks of euro-zone weakness required additional stimulus. For the majority members however, an increase in QE could have created doubts about price stability and therefore they refused to make such policy action right now. Still, with UK pricing pressures clearly receding the prospect of more QE from the BoE has increased, especially if the economic data begins to wobble again."

AUD Hits Fresh 10-Month Lows
Once again, the Australian, New Zealand and Canadian dollars sold off aggressively against the greenback. The recent weakness has taken the AUD and CAD to their lowest levels in 11 months and the NZD to its lowest level in eight months. While New Zealand's economy is probably the strongest, its currency has been hit the hardest on a day to day basis. The decline in commodity prices is contributing to the pressure on the commodity currencies especially the AUD, which has fallen in lockstep with gold prices. Unfortunately the recent rate cut by the RBA and the rise in Australian stocks has not made Australians feel any better about the outlook for the economy. According to Westpac, consumer confidence dropped 7% this month, the largest decline in 17 months. Consumer demand in Canada is also anemic, contributing to the weakness in the loonie. Retail sales were flat in March after growing 0.7% in February and excluding autos sales declined 0.2%. While no major economic reports were expected from the commodity-producing countries, the AUD, NZD and CAD could still endure big moves on the back of Chinese manufacturing numbers. HSBC releases their monthly manufacturing PMI report this evening and if the sector continues to slow, these currencies could extend their losses.

JPY: All Eyes On Weekly MoF Data
It was a mixed day for the Japanese Yen which traded lower against the U.S. dollar and euro but higher against other major currencies. The Ministry of Finance's weekly report on Japanese purchases of foreign bonds are scheduled for release this evening and in order for USD/JPY to extend its gains, this data needs to show that the Japanese are continuing to be net buyers of foreign bonds. With U.S. 10-year yields reaching 2%, the Japanese should find the growing yield opportunities abroad extremely attractive. As much as the Japanese government is trying to keep the Yen weak, the benefits to trade have been limited by sluggish global growth. Japan's trade deficit contracted less than expected in April due to softer than expected export growth. Imports on the other hand rose strongly which is a testament to improving economic conditions in Japan. Overnight, BoJ Governor Kuroda also reaffirmed most of the central banks policies and shrugged off the recent volatility in the JGB market.

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