USD/JPY Crashes Ahead of Next Week's FOMC

We are drawing to a close a week marked by multi-year highs for many currencies. The biggest milestone was reached by the Australian dollar, which climbed to its strongest level in more than 2 years versus the greenback.  The euro was not far behind, marking a 23-month high while the Canadian dollar and Swiss Franc hit one year highs. Sterling and the New Zealand dollar hit 10 month highs although GBP/USD gave up its gains to end the week slightly lower.  The consistency of these moves tell us that they were driven by U.S. dollar weakness and while that is true, improving prospects in some of these countries also make their currencies more attractive.  But many are overbought on a technical basis, leading forex traders to wonder how much further these currencies can rise.

On a 10-year basis, all of the major currency pairs are trading closer to their lows than highs, which means the U.S. dollar is still expensive on a historical basis.  The dollar is strong because the Federal Reserve is raising interest rates but with the Bank of Canada's rate hike this month, they are not the only ones tightening.  U.S. policymakers are still talking about raising interest rates one more time this year, but nearly every piece of U.S. data released this past week casts doubt on the need for additional tightening. Manufacturing activity in the NY and Philadelphia regions slowed in the month of July and builder confidence fell.  While housing starts and building permits rebounded, these improvements were not enough for investors to move on from the surprisingly weak retail sales and consumer price reports reported earlier this month.  With that in mind, the U.S. dollar could rebound on the back of next week's Federal Reserve monetary policy announcement.  No changes are expected from the Fed and Yellen won't be speaking which means the statement will be kept short and sweet.  The central bank will continue to maintain a positive tone, highlighting the strength in the labor market and repeat their expectation that "economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate." Despite the setbacks, there have still been more improvements than deterioration in the U.S. economy since the last monetary policy meeting (see table below).  In other words, they'll keep a December rate hike in play which could be enough for a relief rally in the dollar.  We expect the greenback and USD/JPY in particular to trade with a heavy bias, possibly even drift down to 110.00 at the start of the week, bounce on FOMC, consolidate afterwards and eventually resume its slide into month-end. Second quarter GDP numbers are also due for release at the end of the week and the contraction in spending will weigh on growth.

Yet the greatest risk for euro next week may not be the FOMC rate decision but rather the Eurozone PMI and German IFO reports. Investors will be searching for data to validate their positive outlook for the euro and the European Central Bank's optimistic views.  The July Eurozone PMI reports will play a big role in determining whether EUR/USD tests its 2 year high of 1.1714.  The decline in German investor confidence is a bit of a concern but the strong increase in factory orders and industrial production shows that activity is still strong. We think it is only a matter of time before EUR/USD hits 1.18 and possibly even 1.20 as long as ECB officials don't jawbone the currency.  At this week's monetary policy meeting, European Central Bank President Mario Draghi made it clear that his concerns for low inflation are limited. The ECB is encouraged by the performance of the economy, not particularly concerned about the rise in the currency and plans to make a decision about their QE program in Autumn. Although Draghi said tapering scenarios were not discussed at this meeting and they didn't talk about what will happen in September, the ECB's tease about discussing stimulus tweaks sometime between September and November was enough to satisfy euro bulls, giving them the confidence to take EUR/USD to its strongest level in 23 months.

Sterling on the other hand underperformed on the back of mixed data. At the start of the weak, we learned that consumer prices stagnated in the month of June and while retail sales rose strongly, the increased failed to convince investors that Bank of England Governor Carney is serious about raising interest rates.  After falling in May, spending recovered in June with retail sales rising 0.6%.  Not only was this greater than the 0.4% forecast but it was validated by a 0.9% increase in core retail sales which excludes auto fuel.  While this should have been stemmed the slide in sterling, investors worry that UK investors are spending beyond their means with earnings growth slow. More importantly, although spending rose more than expected, the increase failed to offset the past month's decline and when combined with stagnant consumer price growth, the case for a rate hike in the fall is weak. GBP/USD has support at 1.2875 but the latest decline could take the pair as low as 1.2750.  The U.K. economic calendar is light next week with only second quarter GDP numbers scheduled for release.  The rebound in retail sales will have contributed positively to GDP growth in Q2.

The commodity currencies were on a tear last week with the Australian dollar leading the gains but whether AUD/USD breaks or fails at 80 cents hinges entirely on next week's inflation report.  We know that job growth is very strong but if price growth is weak, a rate hike from the Reserve Bank is still off the table.  We learned this past week that Australia created 62K full time jobs, the second strongest one month increase in full time work since June 2011.  This increase will foster greater consumption, exports and growth.  But AUD/USD came within 10 pips of 80 cents before U-turning in a move that took it below 79 cents.  This was purely profit taking underneath a key technical level because the consistent improvement in the labor market, increase in business confidence, rise in inflation expectations and stronger growth in China should make the central bank less worried about the level of the currency.  Yet if CPI growth falls short, it would provide traders with the perfect excuse to take profits after an exaggerated move especially after RBA member DeBelle said a lower exchange rate isn't helpful and a stronger currency complicates the economy's adjustment.  If it exceeds expectations, it would be a strong enough catalyst to drive AUD/USD above 80 cents.  With no major New Zealand economic reports released this past week, the New Zealand dollar rose in lockstep AUD. The only significant event for NZD was dairy prices which increased marginally.  Unlike Australia, New Zealand has had consistent data disappointments but that seemed to matter little to a market focused on yield. NZD could retrace if next week's trade balance falls short of expectations, which is likely given the drop in the PMI manufacturing index.

The Canadian dollar has been on a relentless uptrend since the Bank of Canada started to talk rate hikes. The rally gained momentum after the BoC raised interest rates last week and suggested it is the beginning of a new monetary policy cycle.  Rising oil prices and stronger data validated the central bank's optimism sending USD/CAD below 1.26.  Retail sales also rose doubled expectations in May although consumer prices grew at a slightly slower pace.  Friday's Canadian economic reports left a lot to be desired with CPI and retail sales ex autos falling -0.1%.  Technically, the pair seems bound for more losses and while 1.25 is an important psychological level, the main technical level to watch for USD/CAD is the 2016 low of 1.2461.