U.S. Yields Hit USD/JPY

Chart: USD/JPY Trails U.S. Yields Intraday

Early gains in the U.S. dollar were wiped out by the end of the North American trading session. The reversal in the greenback can be tied directly to the reversal in U.S. yields. At the beginning of the U.S. session, 10 year Treasury yields were approaching 3% but by the end the day, it dropped below 2.9%. The following chart shows how closely USD/JPY (yellow line) followed U.S. 10 year yields (white line) intraday. Outside of buyers swooping into bonds at key levels, there was no fundamental data to support the move. In fact, Friday's economic reports should have driven the dollar higher as equity investors certainly cheered the upward revision in GDP. Third quarter GDP growth was revised up to 4.1% from a previous forecast of 3.6% and we can't forget that the initial forecast was 2.6%. Between July and September, the U.S. economy grew faster than most policymakers and economists anticipated because the U.S. government shutdown did not do significant damage to consumer consumption. A large part of the day's revision can be attributed to stronger final demand as the personal consumption component of the report was revised up from 1.4% to 2%. Persistent improvements in U.S. data continue to give the Fed confidence that they have made the right decision with unwinding QE. In fact we expect the U.S. recovery to gain momentum in 2014, keeping the central bank on track to taper at almost every meeting next year, bringing QE to a halt by the end of 2014.

The gradual unwinding of stimulus makes the current uptrend in the dollar one that should last well into the New Year. We expect the greenback to perform the best against currencies whose central banks are dovish and looking to ease further - namely JPY, EUR and AUD. We continue to look for USD/JPY to break 105 and the EUR/USD to drop below 1.35. The Federal Reserve's decision to begin its long farewell with Quantitative Easing marks a significant change in U.S. monetary policy. While Janet Yellen's Senate Confirmation hearing has been postponed to January 6, there's no question that she will become the next head of the Federal Reserve and her support of this week's decisions suggests that she may be less dovish next year. Unfortunately we may have to wait until the New Year before the key levels in USD/JPY and EUR/USD are broken because trading grinds to halt over the holidays and no major U.S. economic reports are scheduled for release for the rest of the year. Starting Monday, consolidation should be the main theme of trading.

EUR: Shrugs Off S&P EU Downgrade

Like many major currencies, the euro ended the day unchanged against the U.S. dollar. The decline in German producer prices was not a surprise considering that low price pressures is the main motivation for the European Central Bank's dovish monetary policy bias. The German economy continues to outperform with confidence rising to its highest level since August 2007. However what was surprising was the euro's reaction to the S&P downgrade. Granted Standard & Poor's stripped the European Union and not the euro zone of its prized AAA rating, lowering their credit worthiness level to AA+, many countries in the E.U. are also apart of the European Monetary Union or the EMU. They cited "weaker credit worthiness among the 28 EU member states, including among net creditors to the EU's budget." The agency said, "we consider that the EU's financial arrangements have deteriorated, and that cohesion among members has lessened." Part of the reason why the impact on the euro was small was because investors have come to realize that downgrades don't always scare off investors. The primary risk of a downgrade is higher borrowing cost but because the euro zone's rating was not downgraded yields barely budged. Both the U.S. and euro zone economic calendars are extremely light next week, which means there should be limited movement in the EUR/USD

GBP: Mixed Data Means Consolidation

The British pound traded slightly lower against the U.S. dollar and euro Friday on the back of mixed economic data. To start, third quarter GDP growth was confirmed at 0.8% but the annualized pace was revised up to 1.9% from 1.5%. This upward revision was driven by stronger services and construction activity but those increases was also offset by weaker manufacturing growth. Overall disposable income and consumer demand is strong but a separate report showed the budget and current account deficit widening. The increase in the budget deficit was caused by a rise in investment and deterioration in local finances. The current account deficit on the other hand expanded to its largest level in 24 years. The overall recovery in the U.K. has been strong but Friday's reports show the areas of vulnerability. Growth has been dependent on demand and with the savings rate declining the recovery in the U.K. needs to accelerate to keep the momentum going. With no major U.K. economic reports scheduled for release for the rest of the year, we expect sterling to consolidate and trade in a range between 1.62 and 1.6450.

AUD: Beware Of The Spike In Chinese Rates

It was a busy day for the Canadian dollar, which fell to its lowest level in 3 years on the back of weaker retail sales and softer inflationary pressures. However as the day progressed the U.S. dollar gave up its gains and the Canadian dollar recovered, leaving the currency pair unchanged for the day. According to the latest reports, consumer spending fell 0.1% in October but the decline was driven largely by softer demand for autos because sales excluding autos rose 0.4%. After rising by 1% in July, consumer spending growth has slowed materially. The same is true of consumer prices, which stagnated in November after dropping 0.2% in October. This should leave the Bank of Canada comfortable with the current level of monetary policy and even though Canada's economy has been underperforming, eventually, the sell-off in the loonie will help turn things around. October GDP figures are scheduled for release on Monday and the pace of growth is expected to slow. Meanwhile the Australian and New Zealand dollars traded higher against the greenback. While the New Zealand dollar's rally was supported by the largest rise in credit spending since January 2011, there was no economic data from Australia. Yet the currency pair enjoyed the strongest rally of all the majors Friday because of positioning. Speculators have been holding significant amounts of short Australian dollar / long U.S. dollar positions and some have decided to square their positions ahead of the holidays. The big story out of Asia however is the sharp rise in short term money market rates in China - the 7 day repo rate doubled over the past 5 days, making it incredibly expensive for banks to borrow. The central bank injected liquidity in the market earlier this week to stop the rise but to little effect. If you remember a similar situation happened back in June and at the time, Asian equities and the Australian dollar were hit hard by tighter monetary conditions in China. So far external markets have taken the developments in stride, but the 2% slide in the Shanghai stocks could spillover to other markets.

JPY: Slight Tweak In BoJ Statement Is Positive USD/JPY

After this week's spectacular rally, most of the major currencies ended the day unchanged against the Japanese Yen. The turnaround in U.S. yields took USD/JPY off its intraday high of 104.63 and the sell-off weighed on some of the other yen crosses. As expected, the Bank of Japan left monetary policy unchanged last night, but there was one minor tweak in the statement that made it slightly more dovish. The central bank now sees the year over year increase in CPI likely to rise "for the time being" compared to "gradually," which suggests they expect a slower increase in inflation in the near term. If consumer spending contracts as a result of next year's consumption tax increase, the combination of weaker demand and a slower rise in CPI could drive the central bank to increase stimulus next year. Most of the world is off for the holidays next week but Japan has a significant amount of economic data scheduled for release. This includes the BoJ's monthly report, consumer prices, housing starts, manufacturing PMI, industrial spending, retail sales and the jobless rate. We continue to expect the data to show a rise in inflation, stronger demand, increase in manufacturing activity and an overall improvement in economic performance. The problem is that good data doesn't change the fact that the BoJ is open to boosting QE at a time when the Fed is unwinding its own program. While USD/JPY pulled back Friday, this dynamic should support further gains in the currency pair and encourage a move above 105.

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