Why Did EUR/JPY Hit a Record High?

DailyFX Fundamentals 07-21-08

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar: The one correlation that hasn't faded (yet)

The sell-off in the Dow, the rebound in oil prices and weaker economic data drove the US dollar lower against every major currency except for the New Zealand dollar.

Leading indicators dropped for the second month in a row, as stock prices plunge and unemployment rises.

Even though Bank of America reported better than expected earnings today, the rally in the stock market is running out of gas.

US Treasury Secretary Paulson and Fed President Plosser are scheduled to speak about the economy tomorrow and it may difficult for them to avoid acknowledging the deteriorating outlook for the US economy.

Whether or not the dollar will continue to slide will be largely dependent upon the moves in equities and oil since the US economic calendar is devoid of any significantly market moving data.

Meanwhile, for currency traders, the most interesting article in today's Wall Street Journal is the one about volatility in the financial markets causing trading relationships to be in flux.

This article examines some of the correlations that we talk about regularly, between USD/JPY and stocks or the EUR/USD and oil.

The premise of this article is that these correlations may be fading, even though USD/JPY has traded in sync with the Dow today while the positive correlation between the EUR/USD and oil prices remain intact.

Correlations run hot and cold and even though the Wall Street Journal Article may have a point, there will always be times when correlations are strong and weak.

The one correlation that has remained intact so far is between USD/JPY and the December Fed Fund futures contract.

Since March, the correlation between these two assets has been more than 90%.

This tells us that the US dollar has been trading almost entirely based upon the market's expectations for the Federal Reserve moves this year.

Back in March, USD/JPY plummeted below 100 when Fed fund futures priced in steeper rate cuts.

By June, the greenback recovered impressively against the Yen as oil prices surged forcing Fed fund futures to price in the possibility of rate hike before the end of the year.

Interestingly enough, the correlation between the December Fed fund futures contract and the EUR/USD has been approximately zero between March and July.

The reason why the correlation is strong for USD/JPY but nonexistent for the EUR/USD is simple; everyone knows that Japan can not alter interest rates despite their economic conditions while the outlook for Eurozone rates remains uncertain.

In contrast, weaker conditions in Japan have already been priced into the market, but no one knows for sure if the Eurozone will skirt a recession or whether the European Central Bank will deliver another rate hike this year.

Why did EUR/JPY hit a record high?

The Euro hit a record high against the Japanese Yen in the early US trading session.

The primary reason why the currency pair has rallied 11% over the past 3.5 months is because of US growth - not many people realize that the price action of EUR/JPY is directly correlated with how the US economy is faring.

According to this EUR/JPY chart, there is a strong correlation between manufacturing ISM and EUR/JPY.

The arrows on the chart point to the times when manufacturing ISM had a meaningful dip below the 50 boom / bust level.

This has happened more than seven times over the past 20 years and each time the US manufacturing sector contracted, EUR/JPY rallied. On average, from the month that ISM contracted to the month that ISM moved back above 50, EUR/JPY rallied 314 pips.

Euro edges higher on hawkish comments and Dollar weakness

The Euro edged higher today on US dollar weakness and hawkish ECB comments.

Draghi is the latest ECB member to warn that surging oil has increased inflation risks.

Central bank officials are not giving up on their hawkish monetary policy even though growth is clearly slowing.

The German IFO report is the marquee event on the Eurozone calendar this week.

With Eurozone industrial production falling by the largest amount in a single month since 1992, it is hard to believe that German business confidence improved.

Meanwhile Swiss economic data was slightly better than expected with producer prices beating expectations and the real estate index of family homes edging higher.

The Swiss trade balance is due for release tomorrow. The market expects weaker global growth to weigh on export demand.

BoE comments weigh on the British Pound

Even though the British pound strengthened against the US dollar, the rally was modest at best compared to the performance of the other major currencies.

Aside from the US dollar, the pound weakened against all of the other G10 currencies as the outlook for the UK economy deteriorates.

Bank of England member Blanchflower confirmed what many Britons fear the most, which is that the UK economy is headed for a recession.

Although Blanchflower is typically more dovish than his counterparts, he is right in arguing that the economy will get worse before it gets better.

He calls for the central bank to cut interest rates rapidly to prevent a downturn that could be more severe than the one in the US.

The Bank of England minutes are due for release on Wednesday.

Canadian Dollar rallies ahead of retail sales

The Canadian dollar has strengthened ahead of its retail sales report tomorrow.

The strong rise in wholesale sales suggests that consumer spending should have been strong. The recovery in oil prices is also helping.

The New Zealand dollar was the only the currency to lose value against the greenback today. The overriding fear in the markets right now is that the Reserve Bank will make dovish comments following their monetary policy meeting this week.

Visitor arrivals and credit card spending was weak in June, pointing to weaker consumer spending last month.

The Australian dollar on the other hand edged higher as stronger vehicle sales offset softer producer prices.