Traders See FX Volatility, Event Risk From FOMC, BOJ - Analysts

Yen traders saw FX volatility and event risk arising from this week's Federal Reserve and Bank of Japan meetings.

When the dust has finally settled Friday, the yen could be sharply higher or lower, they said.

Dollar-yen was trading at Y118.55 Monday afternoon, in the middle of a Y118.17 to Y118.86 range.

After peaking at Y123.76 in mid November and Y123.67 and Y123.56 in early to mid December, the pair tumbled into year-end, driven by unwinds of long-term yen short positions. In 2016, safe-haven yen demand weighed further on dollar-yen and yen crosses.

The break of key support at Y118.07 (Oct 15 low) rattled earlier in January, and last week's break of the August 24 (China stock tumble day) lows near Y116.18 again rattled bearish yen sentiment.

At the peak of panic, dollar-yen posted a low of Y115.98 Jan. 20, which was the lowest level seen since Jan. 16, 2015, when dollar-yen troughed at Y115.86.

In the past few weeks, speculative positions have gone from modestly yen short to more sizably yen long.

CFTC data, released Friday, showed that speculative accounts had a net yen long of +37,653 contracts as of Jan. 19, versus last week's net yen long of +25,266 contracts. The Jan. 19 position was the largest net yen long since Feb. 7, 2012 (+55,171 contracts).

This flip-flop in yen positioning was behind the fast-paced dollar-yen gains seen since last Wednesday's drop, traders said.

A decisive close above Friday's high of Y118.78 will target a retest of the psychological Y120 mark, they said.

BOJ actions this week will also hold sway on Japanese stocks.

The Nikkei 225 closed up 0.9% at 17,110.91 Monday, after trading in a 16.922.21 to 17,208.24 range.

This month, the index has seen a range of 16,017.26, seen Jan. 21, to 18,951.12, seen Jan. 4, with the low the lowest level seen since Oct. 31, 2014.

At today's close, the Nikkei 225 is down 10.1% year-to-date and down 18.3% from the 2015 high of 20,952.71, seen June 24.

Recent soft Japanese data and stock and FX market volatility have market players rethinking their view about whether the BOJ will announce new easing measures this week.

BOJ Governor Haruhiko Kuroda, last Friday in an interview with Bloomberg on the sidelines of the World Economic Forum taking place in Davos, Switzerland, seemed to downplay Japan's economic woes and yet keep the door open for easing.

Kuroda noted that the BOJ was "not so much concerned about the real economy," at the moment, but at the same time said "there are many ways to further strengthen and expand QQE even more creatively."

The yen strengthened initially Friday in response to Kuroda's remarks but dollar-yen soon rebounded with the pair closing the week near Y118.78, the highest close since January 5.

Another solid Y118-plus close today in dollar-yen would suggest scope for higher levels, but traders remained cautious ahead of both the Fed and BOJ decisions.

In terms of the Fed, Steve Englander, global head of G-10 FX strategy at CitiFX said Wednesday's FOMC statement "will convey expectations and confidence that the US economy broadly remains on track, but is not meant to give a big signal at a non-Press Conference."

Fed fund futures suggest only one rate hike in the coming 12 months, so the current risk is that such a statement would be viewed as hawkish in light of recent data and global asset market volatility, he said.

Englander looked for a deemed hawkish Fed statement to underpin the dollar versus G5 currencies.

Commodity FX and EMFX have tended to rally "when investors become less risk averse, but we do not think this FOMC Statement will be able to generate that kind of confidence," he said.

"We are more confident that a Fed that signals it is on track will be USD positive against G5 than against EM and commodity currencies," Englander said.

A dovish FOMC surprise would be if they "shifted the balance of risks to the downside" and "saw some risk that inflation expectations were becoming unhinged," he added.

As for the Bank of Japan, RBS put "a 50% probability" that the BOJ keeps policy steady this week, "while lowering its forecasts," which should keep USDJPY in a Y116-Y120 range, said Mansoor Mohi-Uddin, senior market strategist at RBS.

RBS saw about a 10% chance that the central bank keeps both s both its policy and forecasts unchanged, which could send USDJPY down to Y115.

"In our main risk case, we see a 30% probability of higher JGB, REITs and ETF purchases with dollar-yen trading Y120-125," he said.

RBS also saw a 10% chance that the BOJ only raises its REIT and ETF purchases, which could send USDJPY up towards Y120.

"Any surprise BOJ move may be the last round of easing under its current Quantitative and Qualitative Easing framework," Mohi-Uddin said.

"Thus, we would sell any strong rally in dollar-yen above Y120 if the BoJ does - against our base case - ease this week," he said.

Greg Anderson, global head of FX strategy and Stephen Gallo, European Head of FX strategy, at BMO Capital Markets reminded that key CPI data will be released just before the BOJ decision.

MNI's median is +0.1% year-on-year for core national CPI as well as core central Tokyo CPI. The market is looking for whole year numbers of 0.8% year-on-year for overall inflation and 1.0% for core, RBCCM said.

Anderson and Gallo maintained that the central bank will "take advantage of the inflation story" and ease Friday."

The BOJ "incurs too much risk" if it waits until the next meeting (March 15), the strategists said.

BMOCM looked for the BOJ to "either increase its annual asset purchases target to Y100trn or else adopt a negative interest rate."

However, the central bank is unlikely to do both given that such action would leave "the BOJ's quiver seemingly empty in the event that confidence deteriorates further," they said.

On the FX front, "if the BOJ increases asset purchases, we would expect USDJPY to climb to roughly Y122 by Friday's US close" and BMOCM "would expect a move to Y124 if the decision is to adopt a negative interest rate target," Anderson and Gallo said.

Should the central bank "do neither, the kneejerk move is likely to be a quick reversal back down to about Y116.50," the strategists said.

"Unless the BoJ explicitly communicates the possibility of easing policy between meetings, a decision not to ease at this meeting leaves open the possibility of a move as low as Y110 in the event of a further meltdown," they said.