Analysis

5 Things You Should Know About Bank of Japan Meeting

This is an important week in the foreign exchange market and the action kicks off with this evening's Bank of Japan monetary policy announcement. Between the 3 central bank rate decisions, Japan's is the most uncertain and therefore the most likely to trigger breakouts in currencies. All of the Yen pairs including USD/JPY have been trading in tight ranges. There's been a lot of talk that the BoJ could tweak monetary policy and even raise interest rates but based on how the Japanese Yen has been trading, many investors are skeptical about whether the central bank will take any action at all. The problem is that prolonged easing has caused bank profits to shrink significantly and the BoJ has been in and out of the market trying to control the yield curve.

Here are 5 potential changes that the BoJ could make:

1. Raise BoJ yield target

2. Widen the trading band for 10 year yields

3. Change the Yield Curve Control policy framework to target shorter term bonds / assets

4. Redirect ETF purchases from Nikkei to TOPIX

5. Adjust forward guidance

But the problem is that inflation is low and data is weak. At 0.7%, CPI is miles away from the central bank's target and the BoJ may have to acknowledge that by cutting their inflation forecasts. If they were to raise interest rates, it would only drive the Yen higher and prices lower. China, Japan's most important trade partner is also in a heated trade war with the U.S. that is hurting business sentiment and financial market stability. Raising interest rates now would only increase the pressure on exporters especially with the Chinese Yuan weakening as much as it has in the past 3 months.

Raising interest rates would be the boldest move for the BoJ and one that could send USD/JPY below 110 but given the possibility of a lower inflation forecast, they will most likely make a smaller tweak. With that in mind, the Yen would still see sizable gains if they widened the trading band for 10 year yields or shortened the duration of assets purchased. However if they only redirect ETF purchases and/or adjust their forward guidance to suggest that future changes could be made to interest rates or asset purchases, the Yen would either fall or experience only modest gains.

The levels to watch in USD/JPY are 111.50 on the upside and 110.00 on the downside. If 111.50 breaks, we could see the beginning of a new wave of strength that could take USD/JPY to 113. If 110 breaks, USD/JPY could extend its slide to 109, although Yen strength should be the most pronounced against the Swiss Franc and Australian dollar if the BoJ is hawkish.

While USD/JPY will be moving on BoJ, the other major currencies have their own releases to contend with. U.S. personal income, personal spending, Chicago PMI and consumer confidence numbers are scheduled for release. We are looking for the data to soften but if that happens, the impact on the greenback should be limited as Fed hawkishness is all but certain.

This means a pair like EUR/USD will move on its own data releases Tuesday especially because Q2 GDP, July CPI, and July labor market numbers from Germany are important releases. Euro sold off after the ECB left interest rates unchanged last week but the single currency recovered on Monday on a softer dollar. If growth and inflation surprises to the upside, EUR/USD could extend to 1.1750 (the top of its recent range) and even 1.18. Sterling's performance is disappointing considering that the Bank of England is expected to raise interest rates for the first time this year. Despite an uptick in mortgage approvals, GBP rose only slightly versus USD and fell versus the EUR. Investors are concerned that the BoE will be one and done, after which Brexit risks will come creeping back.

All 3 of the commodity currencies started the week firmer with the New Zealand dollar leading the gains. There was no specific explanation for NZD's strength outside of profit taking after extensive losses in the second quarter. Both AUD and NZD will be affected by tonight's Chinese PMI reports and Bank of Japan rate decision. Canadian GDP numbers are due for release on Tuesday and growth should be strong given the sharp increase in retail sales in May. USD/CAD fell to a 1.5 month low and is eyeing a deeper decline towards 1.2960.

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