USD/JPY volatility at an extreme low

USD/JPY will continue to struggle to break higher in the short term, with the currency pair restrained by capped US yields. Indeed US Treasury yields have slipped over recent days. The range bound trading pattern for USD/JPY has resulted in a declining trend in both implied and realized volatility. The drop in volatility has been particularly sharp, with 1 month volatility at an extreme level according to our z-score analysis.

The implication is that it is cheap to USD/JPY volatility although it may need a trigger from a further increase in US yields and / or major improvement in risk appetite to spur an increase in volatility. Comments by the Bank of Japan’s Iwata yesterday that its not necessarily good if the JPY keeps depreciating is not conducive for higher volatility in the currency pair but likely further stimulus from the BoJ alongside wider yield differentials with the US, will mean that downward JPY pressure will resume soon at a more rapid pace in the months ahead.

Why the JPY will weaken

While I continue to forecast JPY weakness over the coming months the JPY is currently being buffeted by various forces. Elevated risk aversion has limited the downside for JPY as the currency has once again found a safe haven bid although it has weakened as risk appetite improved slightly overnight.

Going forward, I expect US Treasury yields to move sharply higher as the US economy gains momentum and loses the shackles of bad weather, pressurising USD/JPY higher. Additionally likely further easing by the BoJ in April / May will contribute to downward pressure on the JPY.

Separately Japan has shifted from possessing a relatively strong broad basic balance surplus (current account + direct investment + portfolio flows) to a deficit, a factor that will undermine the JPY over the coming months.

JPY capped

USD/JPY is being buffeted by the conflicting forces of relatively elevated risk aversion and higher US yields, leaving the currency pair in difficult position to sustain gains. Today’s BoJ outcome has the potential to give some direction but its unlikely that the central bank will deliver any surprises after boosting its funding for lending scheme at the last meeting. Nonetheless, additional easing is likely to take place around as early as April. The emergence of US Treasury buyers as 10 year yields approach 2.8% suggests that US yields may be capped for now and it may take the emergence of more positive / less weather impacted data to push yields higher. Consequently USD/JPY will struggle to make much headway over the short term, with resistance seen around 103.77.

Risk aversion edging higher

As the reverberations from China’s poor trade data, weaker loan growth and money supply, as well as continued tensions in the Ukraine ahead of a referendum next Sunday, spread through the market, risk aversion continues to edge higher according to our risk barometer.

Lingering questions over the weather impact on the US economy are also capping risk appetite even after the better than expected US jobs report at the end of last week. Although there is no sign of any panic selling of risk assets at present the tone is decidedly cautious.

Consequently safe haven assets remain in demand, with for example gold prices holding up well and US Treasury yields being capped. Additionally industrial commodity prices have taken a hit, with iron ore prices under major pressure.

There is little on the agenda today that will give a clearer picture for markets, with the Bank of Japan policy meeting and UK industrial production data, the key events for the day. As a result, caution is likely to prevail.

The week ahead

There are plenty of events to chew on over coming days including central bank decisions in Japan tomorrow and New Zealand on Wednesday. The Bank of Japan is unlikely to ease policy further so soon after its actions to boost loan growth while in contrast the RBNZ is set to begin its hiking cycle. On the data front US releases will still be weather impacted to some extent although February retail sales is likely to post a small gain. Moreover, Michigan confidence is set to rise, boosted by higher equity prices.

In Europe, attention will focus on industrial production releases in January, with French and Spanish IP data due to be released today. Overall production is likely to have expanded at a healthy clip of 0.4% MoM in the Eurozone as indicated by survey data. Finally, Australian jobs data is set to show some improvement on Thursday as the pace of deterioration in job market conditions slows.

In Asia the reverberations from the weaker Chinese data will likely impact sentiment across the region. Exports dropped by whopping 18.1% in February while imports rose more strongly than expected at 10.1% yielding a trade deficit of USD 22.99 billion. Central bank decisions in Korea and Thailand are on tap this week. Thailand is a close call, with risks of another policy rate cut but we expect the BoT to stay on hold. Currencies in Asia strengthened last week led by the IDR and INR. Gains this week will be morel limited, especially against the background of higher US yields.

What to watch in Europe and Japan this week

European equuty markets ended higher last week shrugging off some disappointing manufacturing and service sector survey readings. The highlight of the Eurozone calendar this week is today’s release of the February German IFO business confidence survey which is expected to register a small increase from the 110.6 reading in January, supporting the message that German growth is consolidating over Q1 14.

Eurozone inflation readings will be important too, with the flash reading of February HICP inflation released at the end of the week set to record another soft reading of 0.7% YoY, supporting the case for further policy easing from the European Central Bank soon.

While the EUR may benefit from a firm IFO reading any gains will be short lived. Soft inflation will help cap gains in the currency especially given the renewed warning this weekend by ECB President Draghi of more policy action if needed.

Elsewhere, data this week will reveal that the main measure of Japanese inflation appears to be peaking around 1%, with core inflation set to decline over coming months. After last week’s softer than expected Q4 GDP reading the pressure on the Bank of Japan for monetary action and in turn a weaker JPY will continue.

Meanwhile, Japan’s job data is expected to reveal that the unemployment rate held steady at 3.7% in January. USD/JPY will remain support around its 100 day moving average at 101.65.

USD/JPY edging higher

The release of a much weaker than expected print for Japan’s Q4 GDP placed today’s BoJ meeting in a different light. While there was very little expectation of any policy action by the BoJ today the Bank surprised by increasing its lending program.

While asset purchases were not increased it is unlikely to be long before the BoJ embarks further along this path too. Clearly as the GDP data shows the task to boost growth / end deflation is going to be tough especially given the upcoming consumption tax hike. In other words the potential for future action remains significant.

USD/JPY fell initially on the BoJ outcome but pushed higher after an initial disappointment. The recent widening in the US / Japan yield differential (10 year differential at 224 basis points) indicates that USD/JPY will be supported on the upside, with support around 101.38.

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