USD Rebounding Sharply Against Pressured JPY

US Bull Cycle Over?

The bull cycle in the USD index, which has run for around six years, has come under serious heat this year, mostly fuelled by resurgent strength in European and Canadian currencies. The fall-out from Trump’s election has also weighed heavily on USD as investors were once again left disappointed by Trump’s overpromising and under delivering.

However, the decline in the dollar has had some positives globally, reducing the capital outflow from China and other EM’s with the dissipation in concern for a hard-landing in China, bolstering the overall outlook in Asia. Alongside this, the pickup in European and Asian markets, with a drop in USD has strengthened commodity prices and fuelled a strengthening of economies in resource-producing nations and emerging markets which in turn has exacerbated the USD decline.

US Growth Improving, Inflation Still Lagging

The domestic picture in the US is mixed. Inflation has been heavily subdued for five months now, while expectations of large fiscal stimulus have faded and consumer confidence has failed to take off (September consumer confidence undershot once again). Consequently, interest rates and interest rate expectations remain low. However, if growth can continue to run at above 2% with nearly full employment, price pressures are likely to re-emerge, and the Fed can begin a faster hiking cycle.

Essentially, the US Dollar is waiting for indicators to once again reaffirm the robustness of the economy, most importantly a pickup in inflation. A resurgent US Dollar will clearly translate into lower European currencies as well as the currencies of emerging market and resource-producing nations. JPY should also slide against USD, if the main driver of a USD weakness is the risk-on conditions present in Europe, resource nations, emerging nations, due to pressure from the effective exchange rate.

JPY Outlook Is Bearish

Furthermore, the domestic outlook for the JPY is broadly bearish given a combination of the BOJ’s commitment to further easing and political uncertainty linked to the upcoming snap elections called this week. PM Abe has officially called for a snap election on October 22^nd. In the press conference, which gave little detail, the PM praised his Three Arrow approach and his support for the BOJ’s easing policy. The likelihood of Abe being replaced remains fairly low at this stage, and his reappointment is associated with a strong likelihood of Kuroda being reappointed as BOJ chief which would maintain the status quo in the BOJ and keep JPY pressured.

The BOJ’s “QQE with yield curve control” policy has been extremely effective at keeping JPY rates surpassed while global yields have risen over the last year. The divergence between the BOJ, who remain among the last G10 central banks committed to easing, and other central banks who have taken a more hawkish turn, is likely to widen as the Fed moves back towards a further rate hike, keeping the pressure on JPY.

North Korea Poses Upside JPY Risk

One upside risk for JPY is the potential of an escalation in the tensions between North Korea and the US. Over the last few months, sporadic escalations in this standoff have translated into a higher JPY as a result of safe haven demand. While the situation has quietened down over the last few weeks, there is clearly a simmering and persistent risk here which needs to be monitored. Indeed, a report this week by a South Korean news agency noted that North Korea has been improving its military presence along its eastern border in response to the dispatch of a B-1B by the US.

Technical Perspective

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USD Index recently experienced a false break of the 2016 low finding support at a retest of 2008 high. This area also coincided with the supporting trendline of the large megaphone top pattern. Given the steepness of the decline this year, this is a natural zone for profit taking, and traders will wait to see if the recovery can gather stronger momentum or if trend traders will once again step in and drive price lower.

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USD/JPY continues to rotate within the broad 108 – 114 range which has framed price action for most of this year. After a false break of the prior 2017 low, the price has now reversed and traded higher and is challenging the bearish trend line running from last year’s highs. This range is likely to persist in the short term until the market received a stronger directional driver such as a US rate hike or significant uptick in US rate hike expectations.