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The Market’s Hottest FX Trade Right Now

The Market’s Hottest FX Trade Right Now

Kathy Lien, Technical Strategist

With factors coming together to produce heightened FX volatility, a number of compelling trade possibilities are setting up, but none more attractive than shorting the yen against much stronger counterparts like the US dollar.

The lack of US economic data on Monday did not stop the USDJPY from powering higher. The currency pair climbed to a fresh four- year high of 99.04, extending a move that has taken USDJPY up more than 6.5% since the Bank of Japan (BoJ) announced aggressive new monetary policies last Thursday.

While USDJPY is taking center stage and a possible run to the psychologically important 100 level remains a central focus for forex traders this week, an abundance of Chinese economic data and the beginning of corporate earnings season will also affect currency flows.

The dollar's mixed performance on Monday is an example of what investors should expect in the second quarter as relative performance plays a bigger role in FX movements than risk-on/risk-off trading. The greenback traded higher against the Japanese yen (JPY), British pound (GBP), and Canadian dollar (CAD), but lost value against the euro (EUR), Swiss franc (CHF), and Australian (AUD) and New Zealand (NZD) dollars.

We expect the dollar to outperform the EUR, JPY, and GBP this quarter, but underperform the AUD, NZD, and CAD. Read “The Top 3 FX Trades of the Second Quarter.”

Meanwhile, corporate earnings season kicked off with Alcoa (AA) and will be followed by some financial names this Friday. US stocks may have a difficult time extending last week's record-breaking moves after the abysmal non-farm payroll (NFP) report, however.

The minutes from the March Federal Open Market Committee (FOMC) meeting are scheduled for release later this week, and they will most likely sound optimistic since policymakers did not have that payrolls report on hand before the meeting. As a result, traders should take any talk of tapering asset purchases with a grain of salt because the views of many Fed officials probably changed given that latest jobs data.

No major US economic reports are scheduled for release on Tuesday, but Fed Chairman Ben Bernanke will be speaking on Monday evening and could be asked about his outlook on the economy post payrolls in the Q&A session.

See the complete economic calendar

Chinese consumer and producer price reports are expected to show slower inflationary pressures, and in that case, the People’s Bank of China could retain their modest easing bias, which in the short term would be negative for the Australian dollar. In the long term, however, more flexibility in monetary policy should be positive for China, Australia, and the global economy.

While the CPI numbers are important, the primary focus this week will be Tuesday night's trade balance report.

Key German Data to Impact the Euro

The euro traded higher against the US dollar for the fourth consecutive trading day on Monday on the back of stronger German industrial production. After dropping 0.6% in January, industrial production rose 0.5% in February.

This recovery follows a similar rebound seen in German factory orders and bodes well for Tuesday’s trade balance report, however, there is still potential weakness in Tuesday's release because manufacturing activity declined according to the latest PMI manufacturing report.

Monday’s upside surprise does not remove the risk of weaker growth in the Eurozone's largest economy, and we believe that the extension of the EURUSD breakout from last week will be limited to 1.3135 - 1.32.

The primary reason for the EUR's breakout last week was the European Central Bank (ECB), which failed to lay the foundation for a rate cut and suggested their policy toolbox is empty. These are hardly the words of an optimistic central bank, particularly since ECB President Mario Draghi also stressed the downside risks to the Bank’s outlook.

A rate cut is still on the table, and without a single supervisory mechanism (SSM), other countries could fall victim to the same problems seen recently in Cyprus. In addition, we expect growth to remain weak as austerity measures limit economic activity in the region.

USD/JPY: The Hottest FX Trade on the Market

The biggest movers in the FX market continued to be the Japanese yen crosses, which soared to fresh multi-year highs. Better-than-expected economic data did not provide any support to the yen as investors look at the improvements as validation for the positive effects of the central bank's easy monetary policy.

Thanks to the depreciation in the currency, Japan turned a current account surplus in February and reported a 50% improvement in the trade deficit. The Eco Watchers survey, which measures the sentiment of barbers, taxi drivers, and restaurant workers (the true "men on the street") also soared.

These positive reports give the BoJ stronger reason to push forward with their monetary policy plans. Despite the approximate 29% rally in USDJPY over the past few months, the currency pair has not gotten too expensive. In fact, the ten-year average is 100, and at minimum, a full 30% move from the low would take USDJPY to 103, if not higher.

When it comes to USDJPY, it is important to realize that trends in the pair can last for a very long time and extend further than most would imagine. The 100 level should be only the first stop for USDJPY, and before the end of the second quarter, we expect 105 to be tested.

See related: USD/JPY Sets Sights on Lofty Price Target

The Right Time to Reload British Pound (GBP) Shorts

Second only to the Japanese yen, the British pound also performed weakly against the US dollar on Monday. Sterling fell sharply against the USD and EUR on the back of weaker economic data. Employment confidence declined further in the month of March, according to a survey by Lloyds.

For most of the first quarter, sterling had been in a very strong downtrend, but the currency bottomed in the beginning of March after the Bank of England (BoE) minutes revealed renewed inflation concerns.

Prior to that, investors widely believed that the BoE would ease again, but the focus on price pressures and the impact of a falling currency shut the door on that possibility.

We still believe that this reluctance to ease is only temporary. BoE Governor Mervyn King is stepping down at the end of June, and barring any major financial crisis, the chances of significant changes in monetary policy are slim.

The game changes completely, however, when Mark Carney takes office with a mandate to transform monetary policy. While Carney won’t succeed King as BoE Governor until June, expectations on his level of aggressiveness can start to affect sterling as early as May.

UK economic data has been mixed, and the improvements seen at the beginning of March have since started to fade. The central bank's focus on inflation is very "data dependent" and could change if fiscal consolidation or slower global growth starts to weigh on the economy again.

Aside from the BoE's concerns about inflation, sterling also rallied at the end of the first quarter because the problems in Cyprus drove European investors back into the relative safety of the GBP. If contagion from Cyprus is limited and the euro starts to recover from here, then the quasi-safe-haven status of the GBP will become less attractive to regional investors.

Industrial production and trade numbers are due for release on Tuesday, and any downside surprises could exacerbate sterling weakness.

Record Draught Hits Key Commodity Currency

The Australian and New Zealand dollars both traded lower against the greenback despite weaker economic data and cautionary comments from government officials. Starting with the AUD, construction sector activity contracted sharply in the month of March, as the PCI index dropped to 39.0 from 45.6. While this was not the weakest reading seen in recent months, it is an indication that the housing market has peaked.

The Chinese government called on Australia's Prime Minister to reduce restrictions on foreign investment, and any pullback in housing market activity could encourage her to do so. Yet, the report did not hurt the AUD, which is being pushed higher by demand for AUDJPY.

Business confidence numbers are due for release, and we do not anticipate any major changes since slightly weaker manufacturing activity was offset by stronger services.

The New Zealand dollar also ignored warnings from the Treasury and the Reserve Bank of New Zealand (RBNZ). New Zealand is currently enduring its worst drought in 30 years and the Treasury estimates that the drought could shave a minimum of 0.7% off 2013 GDP growth. The RBNZ, on the other hand, had separate concerns: The bank is worried about the high level of household debt and the impact mortgage credit risk poses on the financial sector.

The Canadian dollar, on the other hand, continued to weaken despite an uptick in the business outlook as investors adjust their positions following last week's disappointing jobs data.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.