By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Markets are falling and the yen is rising. Since the beginning of the month, the Japanese yen is up more than 5% against the U.S. dollar. The yen is a funding currency and it's falling hard as investors bail out of risky trades. In fewer than 7 trading days, USD/JPY has fallen 700 pips and it is not because the market is optimistic on Japan’s economy. In fact, yen strength comes at significant costs for Japan because as an export-dependent nation, many Japanese industries live and die by the yen's value. While smart corporations hedge their yen risk, they are slow to do so and can only hedge a certain percentage of yen gains. So yen strength hurts corporate profitability and, in turn, the economy. In the context of global market volatility and the overall weakness of Japan’s economy, many investors are wondering if the Bank of Japan will intervene to halt the slide in its currency.
The last time the Ministry of Finance ordered the BoJ to intervene was in 2011, after the earthquake and tsunami. The Bank of Japan was very active in the market between 1999 and 2004, but most intervention happened below 110. However between 2003 and 2004, they would buy dollars and sell yen anywhere between 120 and 105 in a desperate attempt to help exporters as the economy struggled with zero growth and deflation. For the better part of 2015, Japan’s economy saw positive growth, but in the fourth quarter, GDP growth is expected to turn negative once again. Inflation remains extremely low and the yen has risen significantly since the BoJ cut interest rates, giving the Japanese government plenty of reasons to intervene. Japanese officials have begun to check prices and warn that they are monitoring the markets closely. Their line in the sand is 115 so if USD/JPY falls any further, the Japanese government could step up to the plate. But for now, they're waiting on 2 things -- the market’s response to Janet Yellen’s testimony and CFTC data on speculative yen positioning.
There’s a lot weighing on Yellen’s shoulders Wednesday because now more than ever, investors are looking for her guidance. The recent sell-off in the dollar, decline in Treasury yields and collapse in the stock market reflect concerns about the U.S. economy and Fed policy. A number of central-bank officials have suggested that rates could remain steady next month and the big question is whether the Fed Chair shares these views. Had Friday’s labor-market report not shown an improvement in the unemployment rate and faster wage growth, we would say Yellen had no choice but to prepare the market for no changes next month. However with 5 weeks to go before the next FOMC meeting, it can be argued that there’s enough strength in the economy for Yellen to keep the door to tightening next month open. While Janet Yellen appears before the House Financial Services committee at 10:30am ET on Wednesday, her testimony and the Fed’s monetary-policy report will be released at 8:30am ET -- so traders need to be prepared for an early morning move.
Tuesday's big gains in EUR/USD tell us that investors are bracing for less hawkishness. Banking troubles in Europe and soaring peripheral-bond yields have not stopped investors from buying euros. The euro is a funding currency and the liquidation of risk-on trades has involved the reversal of euro short trades. However, we are surprised by the extent of EUR/USD strength because the selling this week was sparked by European troubles. Just as the yen's rise will hurt Japan’s economy, the jump in peripheral yields could come back to haunt the euro. Along these lines, the appreciation in the currency also increases the pressure on the ECB to ease, especially following the sharp decline in German industrial production. Investors were looking for a 0.5% increase but IP fell -1.2%.
The British pound also traded lower versus the greenback despite a narrower trade deficit. There’s no question that U.K. exports have been hit hard by weaker European and Chinese growth. However EUR/GBP appreciated more than 10% over the past 2 months, which is extremely stimulative for the U.K. export sector. With no major U.K. economic reports scheduled for release this week, the outlook for sterling will be determined by the market’s appetite for U.S. dollars.
Meanwhile, oil prices continued to fall with WTI Crude dropping 4% to $28.50 a barrel. The day started with strong gains in oil but the turnaround during the North American trading session put USD/CAD on a rollercoaster. Part of the volatility was caused by the Energy Information Administration’s lowered forecast for oil -- it now estimates WTI crude at $37.59 a barrel instead of $38.54. USD/CAD ended the day unchanged but the recent moves in oil suggest that USD/CAD should be trading above 1.40.
Finally, AUD and NZD recovered earlier losses to end the day with only minor losses. While New Zealand house prices grew at a slower pace and Australian business conditions deteriorated, AUD and NZD have been largely driven by risk appetite.