The biggest move in the FX markets today is in the Japanese Yen. The 7% decline in the Nikkei overnight kicked off a wave of deleveraging in the financial markets as investors around the world hit the panic button. What is interesting about the move is that no one is buying U.S. dollars, a currency that generally performs well during risk aversion. The reason is because to de-lever means to reduce positioning and over the past month, investors had been gradually increasing their exposure to U.S. dollars. As a result, they are cutting that exposure today. The move in the dollar has nothing to do with U.S. fundamentals as jobless claims dropped more than expected and house prices increased 1.3%. After rising to 363K the prior week, claims fell to 340K, a number that is consistent with a continued recovery in the U.S. labor market. These improvements keep the Federal Reserve on track to taper asset purchases later this year.

However the burning question on everyone’s minds is not about the dollar but about the Yen. Has the Yen finally hit a bottom and is the rally in USD/JPY over? First and foremost, it is important to understand what triggered the sell-off in USD/JPY. The 10bp surge in ten year U.S. Treasury yields yesterday caused a gap higher in JGB yields which in turn triggered the sell-off in the Nikkei and hence USD/JPY. Weaker Chinese manufacturing PMI numbers added salt to the wound by exacerbating risk aversion and the slide in USD/JPY.

Previously we said there are 3 criteria for a continued rally in USD/JPY 1) rising U.S. bond yields 2) new highs in the Nikkei 3) Japanese purchases of foreign bonds. U.S. bond yields increased sharply on Wednesday and while Fed policy should keep yields in an overall uptrend, they are lower today. The Nikkei has collapsed and according to the Ministry of Finance’s weekly portfolio flows report, Japanese investors were net sellers of foreign bonds last week and the amount they sold completely undoes the buying over the past 3 weeks.

So this reversal in USD/JPY is not just technically driven. It has fundamental support and could extend down to 100 and possibly even 98.50. However we believe that losses will be contained to this level due to the divergence between U.S. and Japanese monetary policies. The recent increase in JGB yields will only give the Bank of Japan greater conviction to ease whereas the recent uptick in U.S. yields will eventually attract Japanese interest.