USD/JPY: Driven By Fundamentals

USD/JPY and Risk of Bank of Japan Easing

Not many U.S. economic reports are scheduled for release in the first half of the week but it will be a busy one in Japan and this could create the unique situation where Japanese fundamentals actually drive movements in USD/JPY. The Bank of Japan was set to make a monetary policy announcement Monday evening and while no quantitative easing change was expected, there was a small but realistic chance that it would increase stimulus. Since the start of the year, there have been many signs that Japan's recovery is slowing and according to the table below, Japan's economy has deteriorated further since the last monetary policy meeting. With the consumption tax schedule to increase in April, the economy is vulnerable to further weakness but throughout the data disappointments, the Bank of Japan expressed extreme confidence in the economy's ability to withstand the tax increase. Only time will tell whether this is blind optimism or an accurate assessment of the economy's resilience. However given the weakness in region, the wider trade deficit and recent sell-off in Japanese stocks, we think it would be smart for the Bank of Japan to increase stimulus now to ensure a steady recovery. If the BoJ surprises the market by expanding its asset purchase program, USD/JPY could jump as high as 105. If they keep the program unchanged and Governor Kuroda suggests that they could increase stimulus in April, USD/JPY would rally but the initial move could be contained to 104. The last time the BoJ expanded its asset purchase program was in April 2013 and this decision took USD/JPY from 93 to 103 in 6 weeks time. If no guidance is provided and the central bank leaves monetary policy unchanged, we expect USD/JPY to drop slightly on the disappointment.

USD: Fed Presidents Agree on Further Labor Market Improvement

Most of the action in the foreign exchange market Monday was concentrated in the Asian and early European trading sessions. The U.S. hours were quiet with many major currencies consolidating in tight ranges. The lack of U.S. economic data played a big role in the lack of volatility and traders will need to get use to this for the next few days because there are no major U.S. economic reports until Thursday. Instead, G10 currencies will be driven by non-U.S. data. Monday for example, subdued trading in the FX market and weakness in equities was driven by significantly weaker Chinese trade numbers. The greenback traded higher versus the British pound and Australian dollar but ended the North American trading session unchanged against the euro, Japanese Yen, Swiss Franc and New Zealand dollar. Fed Presidents Plosser and Evans spoke earlier this morning. Plosser who is a voting member of the FOMC said the unemployment is likely to fall to 6.2% by the end of the year. He found the latest payrolls report encouraging and repeated the Fed's well worn line that the "hurdle for changing the pace of taper is high." As one of the more hawkish members of the central bank, he feels that there are risks to having an overly loose monetary policy. There's a good chance he will be voting for another $10 billion reduction in asset purchases this month. Evans is not a voting member of the FOMC this year but as one of the most dovish members of the central bank, we can't help but take note of his optimistic view that the unemployment rate could drop close to 6% by year-end. Like many of his peers, he feels that the central bank's guidance should be qualitative and not quantitative. At this stage, it seems pretty clear that Janet Yellen will taper by another $10B this month and drop their 6.5% unemployment rate threshold.

EUR Hovers Near 2-Year Highs

With no major Eurozone or U.S. economic reports released Monday or no fresh headlines out of Ukraine, the euro ended the North American trading session unchanged, holding onto its recent gains against the U.S. dollar. The currency pair is hovering near its 2 year high and if Tuesday's German current account and trade balance surprise to the upside, EUR/USD could break through 1.3915. Although weaker secondary Eurozone data and softer Chinese trade numbers prevented risk appetite from improving further, driving EUR/USD higher, last week's better than expected U.S. labor market number and less pessimistic comments from ECB President Draghi should keep the currency pair bid for the time being. Given the improvement in the latest factory orders, industrial production and manufacturing PMI reports, there's a reasonable chance that German exports rebounded in January, leading to a higher trade surplus. Unfortunately Germany continues to be the engine of growth for the region. Industrial production in France contracted 0.2% at the start of the year. Nonetheless investor confidence rose to a 35 month high in March according Sentix, which indicates that the market is optimistic as long as Germany continues to grow. The greatest near term risk for the euro is a deepening of tensions between Russia and Ukraine, but the crisis has taken a backseat to the tragedy and mystery of Malaysian Airlines flight MH370.

GBP: Hit By Profit Taking?

Next to the Australian dollar, the British pound was the day's worst performing currency. What is interesting is that there was no economic data to trigger the move. The selling could be linked to renewed demand for EUR/GBP and/or position adjustments after the large M&A flow last week. According to Friday's CFTC IMM report, long GBP/USD positions were at a 14-month high on the day of the Verizon - Vodafone cash payment. In all likelihood, Monday's move in GBP/USD reflects profit taking in what should be a generally quiet week for the currency pair. The only major pieces of U.K. data scheduled for release this week is Tuesday's industrial production report and Wednesday's trade balance. Economists are looking for IP to grow at a slower pace but given the rise in the PMI manufacturing index and sharp increase in new orders, there's scope for an upside surprise.

CAD: Stronger Housing Data Fails to Take Sting out of Labor Market Weakness

Despite better than expected housing data, the Canadian dollar extended its slide against the greenback. The larger than anticipated increase in housing starts failed to take the sting our of Friday's surprise contraction in Canadian job growth. The Australian dollar on the other hand sold off on the back of weaker Chinese trade data while an uptick in New Zealand manufacturing activity helped to keep NZD/USD steady. We continue to keep an eye on the weakness in Chinese assets. The Chinese Yuan sold off aggressively overnight, experiencing one of the largest one-day declines since December. Chinese stocks were hit hard with the Shanghai Composite dropping more than 2.8%. Although a significantly weaker trade balance triggered the selling, China's central bank has been actively allowing the Chinese Yuan to weaken. After selling off throughout 2011, 2012 and 2013, CNY is down over 10% from its 2014 high. With no U.S. data scheduled for release at the front of this week, Chinese data and FX policy is driving currencies and equities around the world. Over the past two months, the market has been focused on the unexpected weather induced weakness in the U.S. data but slowing Chinese growth is one of main themes of 2014 and one with global ramifications. Countries heavily reliant on Chinese growth such as Australia and Japan will be hit the hardest. The decline in the value of the Yuan also reduces the purchasing power of the Chinese, adding to the pressure on demand. The Yuan could not be moving this aggressively without the ok from the central bank. The rapid turnaround in the currency pair suggests that the People's Bank of China is shifting away from a policy of Yuan appreciation. Their motivation is simple - to use the exchange rate as a means to provide support for the export sector and in turn the overall economy. This morning's Chinese trade numbers show the severity of the problems in exports. The Chinese trade balance plunged into a deficit in the month of February due to a surprise 18% yoy decline in exports (economists had been looking for a 7.5% rise). Although the RBA shifted its monetary policy bias to neutral earlier this year we do not rule out renewed pessimism if Chinese data continues to surprise to the downside. New Zealand credit spending and house prices are scheduled for release this evening - we expect the New Zealand dollar to remain bid ahead of the Reserve Bank's monetary policy decision.

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