USD/JPY Claws Back: Gains Restrained By Yields

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

After yesterday's rally, the U.S. dollar struggled to extend its gains. The greenback sold off against all of the major currencies with the exception of the British pound. With existing home sales rising strongly, the problem were that yields spent most of the day in negative territory. The yield curve also moved to its flattest level since 2007, reflecting the market's doubt on whether inflation will rise. However by the end of the North American session, 10 year Treasury yields bounced off their lows. There was still a lot of back and forth in U.S. rates so USD/JPY failed to recapture yesterday's high near 112.72. Tomorrow's FOMC minutes could help. When the Federal Reserve last met, it left interest rates unchanged and described economic activity as "rising at a solid rate despite storms" and said the labor market will strengthen further. While it did not explicitly say that rates would rise in December, it also did not cast doubt on further tightening. December rate hike expectations currently hover at 97% and based on recent Fed rhetoric, we believe that the November FOMC minutes will reinforce the market's views. If we are right, USD/JPY will hit 113 but with 3 weeks to go before the next Fed meeting, any hesitancy within the Fed will give U.S. dollar traders an excuse to take profits ahead of the long weekend. Either way, 111.70 remains an important support level for USD/JPY and one that should hold regardless of Wednesday's event risk.

The euro extended its losses at the start of the NY trading session but recovered into the close. There's nothing really to report on Germany's political situation but it appears that like Chancellor Angela Merkel, the public prefers a new election over a minority government. Many also argue that Merkel will survive the crisis as the economy is strong and voters may prefer continuity over the uncertainty that a minority government would create. The Christian Democratic Union (CDU) is still the largest party with the greatest support. The only question is whether new elections will really yield different results. Either way, in the near term Merkel is still looking to form a coalition government and new elections will only happen if they abandon these efforts completely. The only euro-positive news were comments from ECB member Coeure who said he expects the central bank to change its monetary policy outlook soon though "soon" meant sometime before September 2018, a long time from now. So in the meantime, while EUR/USD traded higher today it will struggle to recapture 1.18 as there's significant resistance hovering between 1.1760 and 1.1820.

Sterling was flat for most of the day with a slight negative bias. Public sector finances turned negative with borrowing higher in October versus September but the currency's weakness was driven primarily by the comments from Bank of England officials. Ramsden sees a weaker period of UK growth for some time, weaker demand and rising Brexit uncertainty. Cunliffe sees inflation peaking this quarter and is cautious about wage growth. Vlieghe and McCafferty on the other hand were less pessimistic with one seeing wage growth rising and the other seeing the need for higher rates before QE unwind. Chancellor Hammond delivers the budget tomorrow but he's in a difficult position as Conservatives want him to increase spending at a time when there is widespread dissatisfaction with austerity. The Office for Budget Responsibility could also downgrade their outlook for public finances - limiting the Chancellor's ability to change course. Some also view tomorrow's budget as an important test for Hammond as he stands to lose his job in a rumored cabinet reshuffle. Over the past 3 trading days, GBP/USD tested but failed to break above the 50-day SMA and for the time being we believe that gains will be capped by this moving average.

All three of the commodity currencies traded strongly despite factors that should have taken these currencies lower. The New Zealand dollar in particular should have fallen hard on the back of the -3.4% drop in dairy prices. This is the second auction in a row where prices fell more 3% and the fourth auction in a row where prices declined. Although the decline can be attributed to rising production, this is bad news for New Zealand's dairy farmers, the economy and the Reserve Bank of New Zealand. NZD/USD was unfazed by the report but we expect NZD to underperform especially on the back of tomorrow's third-quarter retail sales report. Weaker credit-card spending in the third quarter puts the risk to the downside for one of New Zealand's most important economic reports.

The Australian dollar rebounded strongly on comments from RBA Governor Lowe who said it's more likely that the next move in rates will be up instead of down. While these words ignited a relief rally in the currency, its important to realize that they are firmly neutral as Lowe sees no strong case for near-term adjustment in policy. He's worried about low inflation but encouraged that wage growth appears to have stabilized. The RBA minutes were less encouraging as the focus was on the uncertainty surrounding wage pressures and weaker consumption but the central bank governor's comments allowed traders to shrug off the report quickly. The Canadian dollar also traded higher despite a sharp decline in Canadian bond yields, zero progress at the latest NAFTA meeting and a sharp drop in the wholesale trade report. Economists had been looking for a 0.6% increase but instead sales fell -1.2%. This little report has a strong correlation with the broader Canadian retail sales report, which is scheduled for release on Thursday and implies that spending will fall short of the market's lofty 0.9% forecast.