Tactical Upside in USD/JPY: Bank of America Merrill Lynch

With light positioning, an USD to JPY tactical upside may develop into a bear market rally on policy expectations says Shusuke Yamada at Bank of America Merrill Lynch who writes:

We see the USD/JPY remaining bearish over the medium term (Dollar's 100 Yen risk 02 March 2016).

However, the USD/JPY's sell off into the mid-105 area following the BoJ's April Monetary Policy Meeting (MPM) hinted that the initial decline from June 2015 might have been completed (USD/JPY nearing "policy zone"; unlikely hit 100 this time yet 02 May 2016).

The decline since June formed a corrective wave after which the market often follows with a rebound.

We continue to think USD/JPY could retrace 38.2% of the sell off from 125s to 105s (113s) as we head into the June BoJ MPM, providing tactical upside but also a selling opportunity for long-term investors as the pair's next sell off is likely to emerge into autumn. Below, we explain our diverging short-term vs medium-term views.

In conclusion, a bear-market rally in USD/JPY could have some more leg as:

(1) the consumption tax-rate hike delay and fiscal stimulus could be announced in the coming days and support risk sentiment;

(2) a surprise double Upper/Lower House election cannot be ruled out;

(3) BoJ easing in June is a possibility or at least the market will increasingly price in while the market can price in the Fed's hike more; and (4) the market position is long-yen and underweight Japanese equities.

In light of these factors, USD/JPY will probably continue to have a short-term upward bias into113s in the approach to the BoJ's June Monetary Policy Meeting while the BoJ's actual decision will still be dependent on upcoming data, politics, and financial market conditions.

We will recalibrate our tactical view before the BoJ meeting.

From a medium-term viewpoint, however, this short-term rally in USD/JPY is probably a bear-market rally and can be taken as an opportunity to sell if it materializes.

The period after the July election should see a concentration of bullish yen risk factors:

(1) domestic flow dynamics remaining yen-bullish;

(2) our quants strategy team warns of US equity sell off over the summer and USD/JPY, often more closely correlated with US stocks than with US short-term interest rates, is at an asymmetrical risk from the Fed's policy and the US economy;

(3) protectionism and dollar-negative rhetoric could pick up in the US presidential race around the national convention in the summer;

(4) Jul-Oct has negative USD/JPY seasonality (Chart 8); and (5) a change in the priority of economic policies if constitutional reformists achieve a landslide victory in the July election.