Consider Selling Dollar-Yen

The dollar has surprised many by rallying this month after QEII was announced. The crisis in Europe has overwhelmed other considerations. But the dollar has also rallied against the yen, reaching its highest levels since late Sept yesterday. There are three reasons to expect the dollar to come off against the yen.

First, the higher volatility and greater turmoil in the global capital markets has repeatedly proven to be yen supportive.

Second, perhaps as a function of the flight to the safety of the US Treasury market, US rates have fallen relative to Japanese rates. The 2-year spread now stands at just below 28 bp, down 9 bp from the middle of last week. The premium the US offers over Japan on 10-year money has fallen to 156 bp from 177 in the middle of last week and 190 bp in the middle of the month. Dollar-yen has been highly correlated with these interest rate shifts.

Third, although the dollar has rallied, our discussion with clients and market participants suggest an underlying skepticism of the dollar's strength, which is often explained more in terms of euro weakness. Some participants may look to diversify away from the dollar and the yen offers to be an attractive way to express that view.

Stop on short dollar-yen positions ideally would be placed above yesterday's high near JPY84.40 and there is scope initially toward JPY82.80 and then JPY81.80 in the coming days.