USD/JPY Aims for 110, Beckoning Intervention

USD/JPY fell to a 6 month low today taking out 110 in the process. The currency pair has been under pressure for the past week and the losses accelerated despite stronger than expected U.S. service sector activity. In fact investors completely ignored the ISM report even though services encompasses the largest part of the U.S. economy and this was the first improvement in 5 months. Instead, the sell-off in stocks, risk aversion, drop in Treasury yields and negative momentum pushed USD/JPY to fresh lows. It is clear that traders are trying to test the Bank of Japan's limits because U.S. and Japanese data still support gains in USD/JPY. The U.S. economy is improving (albeit at a slower than anticipated pace) while Japan's economy is weakening. Fed President Evans agrees with Rosengren who sees 2 rate hikes this year which means the Fed could still tighten as the BoJ resumes easing and this alone should limit losses in USD/JPY.

Also, the stronger the Yen rises the greater the problems for the Japan. Most Japanese corporations are hedged at 115 so they are bleeding profits at 110 and lower. The Bank of Japan (BoJ) is a central bank known for having no qualms about intervention. In past years, they have sold Yen often in the open market to control the rise in the currency and there's no better time than now to step in. To get the most bang for their yens, the BoJ always likes to intervene when speculators are long. This way they can stop out specs and use their exit to magnify the turn in the currency. According to the CFTC, long yen positions are at their highest levels since 2008, which makes the currency prime for intervention. While today's intraday bounce off 110 smells like intervention it is more likely to be indicative of option barrier defenses because intervention usually leads to spikes in excess of 70 pips and not 40 or 50 pips. Anyhow, the first step in the battle of the yen is verbal intervention and the second step is physical intervention. Phase 1 started with Chief Cabinet Secretary Suga expressing a "sense of urgency" about FX rates. We expect more jawboning from Japanese policymakers in the days ahead with the possibility of physical intervention if USD/JPY falls much further.

The real test for the dollar tomorrow will be the FOMC minutes because it appears that all policymakers share Janet Yellen's dovish views on the economy and monetary policy. If the minutes are more upbeat and stress the possibility of tightening in 2016, the dollar will recover but if they are sanguine and raise more concerns about the outlook for the U.S. economy, expect new lows in USD/JPY and fresh highs in EUR/USD. Traders should also keep an eye on Fed President Mester and Bullard's comments on Tuesday as they are both voting members of the FOMC.

Considering the losses in other risk currencies, the resilience of EUR/USD is remarkable because for the third day in a row, the euro ended the day unchanged against the U.S. dollar. However at the same time 1.1400 continues to be a very difficult barrier to break. While we believe that it is only a matter of time before EUR/USD tests 1.15, some of this week's European event risks could make the move more challenging. Aside from the downward revision to the Eurozone PMI composite index, the surprise decline in German factory orders points to weaker industrial production numbers tomorrow. Then on Thursday, the euro faces a greater risk of loss than gain on the back of Mario Draghi's comments and the ECB minutes. The central bank unleashed a bold round of easing at their last monetary policy meeting and the minutes could outline all of the reasons why.

Sterling also traded sharply lower against the greenback today despite stronger economic reports. Service sector activity grew at a faster pace in the month of March, driving the PMI composite index up to 53.6 from 52.7. We have seen expansion in the manufacturing, service and construction sectors but that mattered little to the beleaguered currency. Sterling has been falling because of risk aversion and growing fears about Brexit. There's less than 3 months before the U.K. referendum and the risk of holding pounds will only grow as the vote nears. Now that 1.42 has been broken, support in the currency pair is at 1.4050.

USD/CAD on the other hand continued to march higher on the back of a significantly larger than anticipated trade deficit and low oil prices. It appears that the recent strength of the currency is catching up to the economy with exports posting their largest decline since May 2009. Declines were seen in both energy and non-energy exports. However the March IVEY PMI report which is scheduled for release on Wednesday may show some improvement as a similar survey by RBC found manufacturing conditions strengthening last month.

The worst performing currency today was the Australian dollar. While the Reserve Bank of Australia left interest rates unchanged, a wider trade deficit and a surprise contraction in service sector activity weighed heavily on the currency. As reported by our colleague Boris Schlossberg, "In its monthly statement the RBA noted that the Australian economy continued to rebalance away from mining and that the recent appreciation in the Aussie was partly due to the rise in commodity prices." However the RBA also noted that, "monetary developments elsewhere in the world have also played a role" in keeping Aussie elevated and went on to state that, "Under present circumstances, an appreciating exchange rate could complicate the adjustment under way in the economy." Investors interpreted this to mean discomfort with the current level of the currency and sent AUD tumbling lower as a result. In contrast the New Zealand dollar experienced limited losses thanks to an uptick in dairy prices.