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 and Asian FX outlook

JPY is facing a double whammy of upward pressure related to both rising risk aversion and a narrowing US yield advantage over Japan. The latter influence has been significant, with 10 year US Treasury yields dropping by around 70bps since the end of last year, versus 10 year Japanese JGB yields. The net result is that the currency pair has fallen sharply over recent weeks and will remain constrained until US yields resume their ascent.

In the near term the escalation of tensions in the Ukraine will fuel increased safe haven demand for JPY potentially leading to a test of a test of technical support around USD/JPY 100.62 (11 September 13 high). However, strong demand around the 101.20-30 level suggests that it may require another leg lower for US yields to fuel a further sharp drop in USD/JPY.

Asian currencies are set to continue to show some relative resilience to events in Ukraine although a weaker bias is expected. Most currencies remain relatively insensitive to gyrations in risk appetite except KRW which registers the biggest correlation with our risk barometer.

Overall, lower US yields will help provide some support to Asian currencies and investors will continue to differentiate based on domestic factors rather than shifts in risk appetite. Additionally some relative stability in the CNY / CNH may also help to limit pressure on Asian currencies.

US dollar restrained further

The USD will continue to be restrained by poor weather conditions and lower US Treasury yields (around 2.6%), especially against the JPY which has also been supported by higher risk aversion and consequent safe haven demand. The USD index is at threat from dropping to its October 2013 lows around 78.998 (currently 79.828)

A similar story applies to the CHF, with USD/CHF hitting its lowest level since late 2011 around 0.8783. This pattern will not change in the short term, especially given the potential escalation in tensions in the Ukraine, keeping the CHF under upward pressure as safe haven inflows increase. EUR/CHF has dropped sharply as a result, with the resolve of the Swiss National Bank to support its line in the sand at 1.20 set to be tested shortly.

Risk currencies in contrast will likely come under growing short term pressure including AUD, NZD and many emerging market currencies. AUD/USD will likely trade with a heavy tone even though the RBA is unlikely to cut policy rates at its meeting tomorrow.

EUR benefitted from the upside surprise for Eurozone inflation but has run into resistance around 1.3800 versus USD. Speculative EUR positioning has continued to rise but the fact that CFTC IMM positioning has risen to above its 3 month average suggests that further EUR gains will be more limited.

Indeed although the USD continues to be restrained by weaker data and lower US yields, the potential for a dovish surprise from the ECB will limit the ability of the EUR to capitalise on USD weakness this week. Strong technical resistance for EUR/USD will be found around 1.3894 (2013 high).

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EUR and JPY outlook

EUR/USD took some advantage of a softer USD tone, with the currency pair breaking above 1.37 once again. However, the release of flash Eurozone HICP inflation readings today will take the shine off the EUR given that it will likely support the case for further policy easing at the 6 March European Central Bank policy meeting.

Benign readings for both headline and core inflation estimates are expected to be revealed today, consistent with small cuts in the ECB’s refi rate and strengthened forward guidance. EUR/USD will find strong resistance around its 2014 high at 1.3776.

Japan’s data slate released this morning came in better than expected. The jobless rate held at low level at 3.7% while the jobs to applicants’ ratio increased to 1.04 in a further sign of strengthening job conditions. CPI inflation marked its 8th straight month of gains while industrial production, retail sales and overall household spending beat expectations.

The main take away is that inflation is close to peaking and the risks of further Bank of Japan policy action is rising. This will limit the downside for USD/JPY but further slippage in US yields overnight mean that USD/JPY upside remains restrained. 101.67 – 102.85 is likely to hold as a near term range for the currency pair.

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China worries inflicting damage globally

A combination of worries on both sides of the pond has inflicted damage on risk assets globally. US equities closed lower, Treasury yields dropped, USD was weaker while gold prices rose. In Asia, China growth concerns, overexpansion of credit, and currency weakness are increasingly infiltrating markets globally.

Meanwhile in the US, consumer confidence surprisingly slipped in February, albeit from a high level while the annual pace of house price gains slowed slightly in December. The data added a further layer of pressure on stock markets and US January new home sales data will not help matters as it is likely to give further evidence of slowing housing momentum.

While it is now easy to blame much of the weakness in US economic data on adverse weather conditions hopes / expectations that US data will improve going forward will be tested soon. In the absence of first tier data today, attention will remain firmly fixed on events in China and in particular whether the CNY and CNH registers further declines.

Given all the attention on the Chinese currency, major currency markets have been lulled into tight ranges, with our measure of composite implied G3 FX volatility declining further. Our implied volatility index has now dropped to the lowest levels since the end of October last year.

USD/JPY is likely to face some downward pressure in the short term given the rise in risk aversion and lower US yields overnight. EUR/USD remains supported but remains susceptible to downside risks given the potential for easier monetary policy at the upcoming European Central Bank meeting next week.

AUD resilient, JPY downside risks

Against the backdrop of concerns about Chinese growth and a weaker path for China’s currency, the AUD has failed to make any headway over recent days. Perhaps more interesting is the fact that AUD remains one of the best performing currencies despite such concerns. From a positioning perspective the market is still net short AUD, albeit less so over recent weeks, implying that there is still scope for short covering.

The rally in commodity prices over recent days will likely have helped the AUD but notably it’s the wrong commodities that are rallying. For instance, iron ore prices have dropped sharply. Nonetheless, improving risk appetite is giving AUD some relief and downside risks to the currency remain limited, with its resilience set to continue. Consequently AUD/USD is set to see strong buying interest on any dip to technical support around 0.927.

USD/JPY has been range bound over recent sessions failing to make any significant headway above the 102.50 level. The consolidation in US Treasury yields is a factor capping gains in USD/JPY but an improvement in risk appetite and gains in Japanese equity markets will likely help fuel some downside risks for JPY over the near term.

There are also signs that after several weeks of net inflows, Japan is finally beginning to register renewed outflows of portfolio capital which ought to add further downward pressure on the JPY. The fact that the speculative market remains net short JPY may limit the pace of JPY depreciation, however. It is difficult to see JPY volatility decline further from already very low levels but a break of current ranges may require a bigger move in US Treasury yields. We remain long USD/JPY at 102.39.

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