We think FX investors should differentiate between the trend and the correction. The USD is within a secular uptrend driven by relative return differentials which themselves find their foundation in a global output gap differential.
Hence any USD setback should be regarded as welcome to add to USD longs. This applies especially for our main call suggesting a medium term USDJPY target of 130 or higher. Mondays 111.35 USDJPY low should now limit the downside
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Japan equityin flows= Weaker JPY. When plotting the performance of DM and EM local equity markets in the last 6 weeks vs the performance of their currencies vs the USD, we find a nice inverse relationship. This makes sense as a strong equity market is often a sign of local economic growth potential and equity market inflows from foreigners. However, there is one outlier, the JPY, which has weakened at the same time as receiving equity inflows. Analysis from our QDS team taking data from the Tokyo Stock Exchange shows that cumulative Foreigner equity positioning was only 56% of previous peak exposure, suggesting further upside here. The BoJ's Sakurai said yesterday the BoJ will continue to provide a stubborn effort across a wide front to escape deflation, which includes buying lots of JGBs and continuing fiscal spending. The Nikkei is reporting that Japan is considering issuing more deficit bonds to cover the tax shortfall. Even if issuance increases,yields are expected to be capped by the BoJ, keeping the yield differential wide and supporting USDJPY. Japan's life insurers also continue to exhibit strong demand for USD assets despite a widening USDJPY basis. The chart below shows that their hedge ratios are too high and the adjustment process will limit and JPY upside
Our more constructive GBP outlook is paying early dividends as the UK government appears to takes a more realistic position in respect of maintaining access to the common market. Yesterday, Brexit Minister Davis suggested the UK would consider paying for EMU market access. Even if his comments were not a new line from the conservative party (May's speech at the party conference said an end to contributions was not a red line), the FX markets were more optimistic after a similar line came from EU side. Dutch Finance Minister Dijsselbloem, who is also president of the Eurogroup, suggested that the EU could design a way for the UK to enter the internal market but it would not be as easy or cheap as it is now. GBP longs towards 1.30 offer a good opportunity to weather any short term USD setback.
**Morgan Stanley booked a massive 1570 pips profit on its GBP/JPY long position as the trade hit its 144 target on Thursday.