JPY retracement, AUD restrained

Equity markets looked more restrained overnight as the sharp rally so far this year stalled ahead of the US Q4 earnings season which kicks off with Alcoa earnings after the close today. The looming budget battle in the US has also prompted some hesitancy to buy risk assets.

Direction will remain limited given the notable absence of first tier data releases today, with only Eurozone economic sentiment gauges, German factory orders, US small business confidence and consumer credit on tap. The bulk of releases are due in the later part of the week including rate decisions from the ECB and BoE.

For a currency that spent most of last year trapped in a relatively tight the JPY has lost an incredible amount of ground (12.7%) versus USD since the beginning of October 2012. The historically strong relationship between bond yield differentials and USD/JPY has broken down (albeit temporarily in my view), and cannot be used to explain the jump in USD/JPY.

Expectations of more aggressive monetary policy action have pushed USD/JPY higher especially as Prime Minister Abe continues to highlight his desire for a 2% inflation target. Nonetheless, as wires report today there may be no deadline for achieving this target a factor which may help USD/JPY to push lower in the short term. USD/JPY is likely to find some support around 86.54 (Jan 2 low). Speculative positioning in JPY has become increasingly short but notably is a long way from the all time low, suggesting scope remains for an eventual increase in JPY shorts.

AUD/USD has made an impressive recovery from its lows around 1.0344 at the end of last year. Risk appetite and the USD index both register a limited and insignificant correlation with AUD/USD suggesting that the currency will not be influenced by either over coming weeks. Yield differentials however, remain important and the widening of Australia 2 year yield differentials with Treasuries has provided important support for AUD.

Further upside in the currency will require Australian yields to move higher and this may in turn depend on the outcome of November retail sales data tomorrow but 2 year yields have hit trend line resistance suggesting that the AUD will struggle to move higher from current levels. AUD/USD 1.0585 will offer strong resistance, while my quantitative model suggests AUD/USD short term fair value around 1.0557.

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