3 Reasons for the Drop in USD/JPY

Buying USD/JPY after the Bank of Japan cut interest rates to negative levels is one of our favorite trades. We are not alone in this view as many major banks are calling for further gains with BNP Paribas forecasting a rise to 124.27, Deutsche Bank thinks it will reach the 125 to128 range and Goldman Sachs is looking for the pair to hit 130 in 12 months time. Yet since the BoJ eased, USD/JPY has struggled to extend its gains and instead fell for the second day in a row. There are 3 reasons for today's decline in USD/JPY - Treasury yields fell sharply, stocks dropped over 300 points intraday and the 200-day SMA at 121.50 is proving to be formidable resistance. With no major U.S. economic reports released today, the simultaneous decline in oil, yields and stocks reflects the market's concerns about growth and the likelihood of delayed Fed tightening. While we also believe that the bar is high for a rate hike in March, the meeting is still 6 weeks away. Between now and then we could still see a run above 122 and even after the March meeting, the contrast between the Fed and the BoJ's monetary policy biases should keep USD/JPY well supported. Bank of Japan Governor Kuroda speaks tonight and we believe he will remind the market that they are prepared to increase stimulus, which could reignite the decline in the Yen.

During the North American session, ADP and non-manufacturing ISM are scheduled for release - two of the most important leading indicators for Friday's non-farm payrolls report. December was a very strong month for jobs so a pullback is very likely but the market will be satisfied with ADP above 200k and ISM rising. The recent small but steady uptick in the ISM manufacturing index along with the rise in consumer confidence point to stronger service sector activity and if we are right it would be supportive of USD/JPY.

We've seen big moves in commodity currencies in the past 24 hours. The Canadian, Australian and New Zealand dollars fell nearly 1% intraday. For 2 days in a row we've seen sharp declines in oil prices and USD/CAD is finally waking up to the move. In yesterday's note we wrote about how the dip in the face of falling oil and a yield spread in favor of USD/CAD made the pair an extremely attractive buying opportunity. Today, USD/CAD is back above 1.40 and poised for a move towards 1.4200.

The New Zealand dollar is under pressure after dairy prices dropped -7.4%, the largest decline since November 2015. There have been 3 dairy auctions since the beginning of the year and pries fell at all 3 auctions sparking talk that Fonterra could lower its payout to farmers. OpenCountry Dairy, New Zealand's second largest dairy processor behind Fonterra has already reduced its milk payout by 30c. Fonterra took the first step of cutting their milk forecast price so a lower payout is probably next. Weaker earnings for dairy farmers would put pressure on the RBNZ to ease.

For next 48 hours we will be watching sterling very closely. UK PMI services are scheduled for release on Wednesday followed by the Bank of England's monetary policy announcement and Quarterly Inflation Report on Thursday. Despite a weaker construction PMI report, sterling held onto yesterday's gains as investors look forward to this week's rate decision. Signs of progress on a deal to avoid a Brexit also lent support to the currency. Brexit is the greatest risk that the U.K. faces this year and if it is removed we could see a significant relief rally in the currency. We'll publish our U.K. data calendar tomorrow after PMI services but so far what we've seen is more improvement than deterioration in the U.K. economy since the January meeting. If tomorrow's PMI report shows acceleration in service sector activity, we could see a stronger short squeeze in the currency pre-BoE.

Meanwhile euro was supported by better than expected German labor data. 20k people dropped off unemployment rolls compared to -8k expected driving the unemployment rate down to a record low of 6.2%. While the ECB is warning of more stimulus, there are definitely signs of improvement in the Eurozone's largest economy. However low inflation, global market uncertainty and Chinese growth are the main areas of concern for the ECB and unfortunately we have yet to see any improvements on this front.

Finally the Reserve Bank of Australia left interest rates unchanged at 2% last night. The Australian dollar initially shot higher when the central bank expressed confidence that the economy is strengthening but its gains were erased just as quickly on their warning that they are watching the economy closely. The RBA said, "Over the period ahead, new information should allow the Board to judge whether the recent improvement in labour market conditions is continuing and whether the recent financial turbulence portends weaker global and domestic demand. Continued low inflation may provide scope for easier policy, should that be appropriate to lend support to demand." In other words the door remains open for additional easing.