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What Happens To JPY If USA Attacks North Korea?

By Kathy LienForexAug 12, 2017 00:06
What Happens To JPY If USA Attacks North Korea?
By Kathy Lien   |  Aug 12, 2017 00:06
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By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.

The biggest driver of currency flows this past week had nothing to do with monetary policy or economic data. Instead, the escalation of tensions between the U.S. and North Korea sent USD/JPY sharply lower as investors worry that this heated exchange could result in military action. Although we firmly believe that the threat of war — let alone nuclear war — is slim, as this era has been one of the most unpredictable in history. Bottom line? Be prepared for the unexpected. Many of our readers are asking how far the dollar could fall if the U.S. goes to war with North Korea but before discussing this, we want to point out that while the dollar is down sharply this week versus the yen, it strengthened against other major currencies like sterling and Australian and New Zealand dollars. So while there’s no question that war is negative for USD/JPY, it can initially drive the dollar higher against high-beta currencies such as AUD and NZD. As a rule of thumb, the Japanese yen and Swiss franc perform best during times of war, which means all the yen crosses, including USD/JPY, will weaken.

Taking a look at some of the major military conflicts over the past 3 decades, the Dollar Index suffers greatly when there is war.
Not only does the cost of war require an expansion of money supply, commodity prices also tend to rise, putting additional pressure on the U.S. economy. In the 2 months from when the conflicts in Libya started, the Dollar Index dropped nearly 5% while during the first 3 months of the second Gulf War, the index fell more than 9%. We saw similar weakness after the first Gulf War and then later when there were missile attacks on Baghdad. U.S. stocks tend to perform poorly, though generally during the month before war begins rather than the month after. This time around, how currencies behave depends largely on how China responds. If China stays neutral and doesn’t provide any support to North Korea, the yen, Australian and New Zealand dollars will have a smaller reaction (although still a big one) than if China inserts itself in the conflict. Since there’s no doubt that North Korea will lose and lose quickly, as the tensions grow the dollar will suffer and the actual announcement of war could take USD/JPY to 105. But if a swift victory transpired, the pair would recover quickly. The bottom line is that the outlook for USD/JPY is grim and 108.50/108.00 is probably the next stop for the pair.

Aside from the threat of war, U.S. data has been far from impressive with jobless claims rising as inflationary pressures remain subdued.
Monetary policy committee members aren’t happy with the current state of inflation and their feelings are reinforced by the weaker-than-expected consumer- and producer-price reports. According to Fed President Dudley, it will take some time for inflation to rise to 2% as the weaker dollar affects import prices. As a result, year-over-year price measures will be depressed for a while and the economy may be a bit more sluggish on the margin. Dudley is one of the main architects of Fed policy and his cautious views confirm that the central bank is in no rush to raise interest rates. This sentiment is shared by FOMC voter Evans and Fed President Bullard. Looking ahead, the most important releases on the U.S. calendar will be the FOMC minutes and U.S. retail sales. Although consumer spending could be supported by the rise in wages and rally in stocks, the Fed minutes are likely to be less hawkish as the central bank doesn’t seem to want to commit much beyond September balance-sheet normalization.

Meanwhile, the risk aversion created by U.S./North Korea tensions also put significant pressure on commodity currencies.
The New Zealand dollar was the worst performer and more losses are likely in the coming week. According to Governor Wheeler, the Reserve Bank is not happy with the value of the currency as he brought up the possibility of intervention after this month’s monetary policy announcement. The RBNZ left interest rates unchanged at 1.75% and said inflation could decline further in coming quarters. Wheeler also talked about how currency intervention is always an option. Assistant Governor McDermott emphasized the significance of Wheeler’s comments by saying the RBNZ changed the NZD language to signal their unease — the first step toward possible intervention. The RBNZ opened up a can of worms and next week’s PMI services, retail sales and producer price reports probably won’t lend much support to the currency, especially after the slowdown in manufacturing PMI index. We see NZD/USD falling back to 0.7250 and possibly even 0.7200.

Unlike the New Zealand dollar, the Australian dollar quietly drifted lower this past week as the threat of war is positive for gold and commodity prices, which is good for AUD.
U.S. Treasury yields also fell more aggressively than Australian bond rates and this change in the yield spread helped to limit the slide in AUD/USD. With that in mind, the Australian dollar is still a high-beta currency and for that reason it will not be able to escape the pressure of risk aversion. The only hope is next week’s Australian employment report because according to the latest PMI numbers, solid job growth was seen in the manufacturing and service sectors. But before we get to that, the RBA minutes will be released and given the central bank’s downgrades, the tone isn’t expected to support the currency. AUD/USD traders should also be watching China’s latest retail sales and industrial production numbers and resistance at 0.7950.

It was a week of recovery for USD/CAD, which experienced its first down day in 10 trading days on Friday.
No major economic reports were released but for most of the week, the pair was lifted by short covering, the sell-off in risk currencies and oil's $50 resistance. However fundamentals still support a stronger currency and we think there could be a recovery for the Canadian dollar and a sell-off in USD/CAD in the week ahead. The only piece of Canadian data worth watching will be Canadian CPI, which is expected to be positive for the currency as the price component of latest IVEY PMI report increased sharply over the previous month. If inflation and employment conditions strengthen, loonie traders will start to argue for another Bank of Canada rate hike this year.

Sterling also drifted lower this week but the losses were limited with 1.2950 holding as support, which is surprising given the unambiguously dovish Bank of England monetary policy statement and Quarterly Inflation report.
Next week will be an important one for the British pound. We still think GBP is headed lower but how sterling trades now hinges on next week’s economic reports. Of all the G7 nations, the U.K. has the busiest data calendar. Inflation, employment and retail sales numbers are due for release and while inflation and spending is likely to be weaker, labor-market conditions seem to have improved significantly according to the PMI reports. The levels to watch for GBP are 1.3060 on the upside and 1.2930 on the downside.

No news has been good news for the euro. Of all the major currencies, it has been the most resilient.
It outperformed the U.S. dollar, sterling and all the commodity currencies. With no major economic reports released, it was riding on the momentum of last month’s stronger releases and the ECB’s optimism. But at times, it also struggled under the pressure of risk aversion. Looking ahead, Eurozone industrial production, GDP, trade and inflation numbers are due for release. German data has been relatively healthy but there’s been weakness in France, so the regional reports could be mixed. Aside from CPI, most of these reports are not expected to have a significant impact on the euro. As such, we continue to look for the euro to outperform the USD, GBP and NZD but weaken against the JPY and possibly, CAD.

What Happens To JPY If USA Attacks North Korea?

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What Happens To JPY If USA Attacks North Korea?

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