Prepare for pivotal week in FX

As I wrote in yesterday's FX newsletter, traders should prepare for a pivotal week in the foreign exchange market with both the BoJ and the Fed holding important policy meetings.

Judging by the major banks' research reports, most analysts expect the BoJ to attempt to steepen the JGB yield curve, but the effect that would have on the JPY remains open to interpretation. It will perhaps be more crucial that the BoJ can convince the market that it is not running out of options to step up its easing measures if required, but that will be a tough task to achieve without support from Japan's Ministry of Finance. While I expect JPY strength to come to an end soon, the Japanese currency remains supported by the unwinding of carry trades and next week's central bank meetings will provide plenty of downside risk for my base scenario. Given this uncertainty, I'm afraid USDJPY might test the 100 level if neither the BoJ nor the Fed can reintroduce JPY weakness and USD strength, respectively. I hold a USDJPY long position with a S/L just below 100 and a short-term target at 105.

Speaking of the Fed, don't expect too much from Yellen & Co.! A rate hike would be a big surprise that would push EURUSD below 1.10 and USDJPY above 105, but the more likely scenario is that the Fed will (once again) not hike and merely introduce a slightly more hawkish tone to its statement instead. Although that should signal perhaps one rate hike by the end of the year, it will not be broadly USD-supportive and thus the risk of temporary EURUSD and USDJPY volatility without a sustainable breakout from recent price channels remains high, i.e. there will be a lot of risk in the market but the likelihood of an adequate compensation for that risk remains relatively low. Risk-averse traders will remain on the sidelines. Those open to more speculative positions will put on EURUSD short, GBPUSD short and USDJPY long trades.

Buy the USD, but against which currency?

I still believe the US dollar will be stronger going forward and I think that its recent weakness presents an excellent buying opportunity. As I wrote in March 2015, there was no reason for the EURUSD exchange rate to go up at that time, unless the Fed would change course and oppose the dollar's strength. Well, that is exactly what happened, unfortunately:

The Federal Reserve has still not hiked rates and some even doubt that it will do so in 2016, while both the ECB and the BoJ have embarrassed themselves by botching up press conferences or entering negative interest rate territory, only to see their currencies go up in value afterwards.

The USD has lost versus most peer currencies, especially the JPY. It's still difficult for me to understand why people have been so concerned about the US economy lately. Every data release that was even slightly below expectations quickly led to more USD selling and EUR or JPY buying. As a result, USDJPY is now fighting not to fall below ¥105 (or even ¥100) while EURUSD recently tried to break above $1.15 (although it has so far failed to do so). The American economy isn't doing that bad, and market participants' obsession with the unemployment rate has reached an outright ridiculous level. At this point it's all about productivity figures!

Anyhow, speculative USD short positions are the highest since 2013. That's a good sign for traders: The extreme EUR & JPY short positions that were the cause of much volatility in 2015 have been reduced substantially, providing new entry opportunities without the risk of extremely sharp moves as in April and December 2015. Market positioning is way more neutral now, which is also a result of investors' inability to interpret central bank actions. Most likely central bankers don't really know what they're doing themselves anymore, so traders are now looking for new reference points that will help them navigate through the muddy waters that are the financial markets. Fundamentals in the US are still better than in Europe and Japan, despite the recent string of disappointing data releases.

But which currency to sell versus the dollar if you share my view? I don't really think the ECB holds much credibility in the markets anymore. Also, Draghi and his team have repeatedly said that they wouldn't introduce new policy measures in the near future because the implemented policy tools needed time to have an effect on the economy. Europe's central bankers are probably too busy discussing their independence from politicians anyway. I expect the EUR to remain range-bound for the time being -- although I must acknowledge that the sideways range in EURUSD has been going on for what looks like a disproportionately long time when comparing it to similar patterns in the exchange rate's history. Be that as it may, the BoJ seems more likely to surprise markets by introducing new easing measures. It is also in a very tricky position now where it has to make decisions within very little room for action around the zero bound. Just how negative can you go, after all? Japan's still fragile economy is in a tough spot here, and I believe both fundamentals and further BoJ actions will reverse the JPY's bout of strength into extended weakness by the end of this year. Conclusion: I'm a USDJPY buyer.

January 2015 Nonfarm Payrolls lift USD

Yesterday the U.S. Bureau of Labor Statistics (BLS) reported that total nonfarm payroll employment increased by 257,000 in January 2015 and that the unemployment rate rose to 5.7% from 5.6%. The market had been expecting an NFP release of roughly 228k, according to a Bloomberg survey of economists. In addition, the BLS revised the November 2014 NFP number to 423k from 353k. The preliminary December 2014 revision stands at 329k versus the original release of 252k. That suggests that more than 1 million jobs may have been added in the nonfarm labour market since October of last year, painting a more optimistic picture for the US labour market.

2014 Revisions in Nonfarm Employment
2014 Revisions in Nonfarm Employment (Source: U.S. Bureau of Labor Statistics)

The increase in the unemployment rate may surprise some analysts considering the strong NFP print, but the change may merely have been a result of a disproportionate 0.2% increase in the labour force participation rate (62.9% after 62.7% in December 2014), which is encouraging given that slightly more people are now looking for opportunities in the improving jobs market.

When the number came out at 1:30pm London time, the USDJPY exchange rate jumped almost instantly to Y119 all the way from Y117.2 and EURUSD fell more than one cent to $1.1311 from $1.1459. Currency traders certainly cannot complain about a lack of volatility in the FX market in January and the first days of February. Intraday swings and the return of lasting price trends have provided many trade opportunities for investors. I still expect EURUSD to trade somewhere between parity and $1.1 by the end of the year. The case is similar for USDJPY with the Bank of Japan still set on printing more money to aid its economy. The strong employment numbers from the United States put a possible first Fed rate hike in mid-2015 back on the table.

EURUSD at key 1.2746 support level

EURUSD Daily Chart 2014-09-25Draghi has been busy giving interviews and speeches throughout the week, all the way preaching his sermon of monetary policy that "will stay accommodative for an extended period of time", dirty deeds that need to be done because "the risks of doing too little are bigger than the risks of doing too much" (a.k.a. "let's throw some stuff and see what sticks"), and "additional unconventional measures" that the ECB stands ready to employ if needed.

The market was quick to react: EURUSD dipped below $1.27 in early trading but later recovered a bit to trade just above the $1.2746 support level dating back to mid-2013.

In late London trading the US dollar retreated somewhat following worse-than-expected durable goods orders and rekindled worries about China's economy. In a risk-off environment that also saw the major equity indices lose 1-2% across the board, EM currencies were the biggest losers and the JPY had its comeback as a safe haven currency.

We still expect EURUSD to fall to $1.25 and USDJPY to climb towards Y110 in the medium term. However, for EURUSD we are closely watching support levels and fibs, because a short-term correction to $1.30 would be perfectly plausible after the sharp USD appreciation and given the many uncertainties currently in the market. If the $1.2746 support holds tomorrow, we will take profits. (Risk seekers might even fancy a quick long trade.) For USDJPY we would still like to see Y107.5 before going long again.