Forex Update - USD

Focus shifts to FOMC, USDJPY and EURJPY initially pushed lower this morning in response to a number of comments by European officials after the G7 meeting that the JPY was too weak relative to Japan's recovery.

Also Japan Finance Minister Tanigaki's conceded that the JPY could probably strengthen as the economy improved further.

USDJPY traded to a low of 117.15 but the move not sustained and has subsequently squeezed back up to around 117.70 levels. Our interpretation of the developments on the weekend were if anything slightly bullish at the margin for the USD and bearish for the JPY given that CNY was less of an issue and also that BOJ Fukui maintained a very dovish stance.

After all, at the end of the day it is yield differentials that are driving the JPY. The text on the FX markets in the main body of the communique was identical to the April Statement.

However, there was no appendix this time and hence no explicit call for an appreciation of CNY, but rather a call for greater flexibility so that "necessary adjustments" can occur. Of the comments that came out from the various officials following the meeting, most notable was the dovish stance of BOJ Governor Fukui and the desire by European officials to talk down EURJPY.

BOJ Governor Fukui said that the G7 understood that the BOJ was in no hurry to lift rates and that there was no criticism of Japanese monetary policy at the meeting.

Meanwhile, European officials said that the JPY should reflect Japan's exit from zero inflation and overall recovery, while Japan's Finance Minister Tanigaki conceded that the move in EURJPY had been "abrupt".

Finally Treasury Secretary Paulson's took a muted approach, warning that protectionist measures were a threat to global growth, and said that he did not have a specific target for CNY.

The focus will quickly shift to this week's FOMC meeting on Wednesday. The market is now pricing no chance of a Fed hike and we expect the statement to remain largely unchanged from last time, in line with recent Fed comments. This should do little to bolster expectations for renewed tightening later in the year, leaving the USD vulnerable to eroding carry advantage, even though the weekend's events have not provided a catalyst for a weaker USD.

The TIC portfolio report for July is due at 1300 GMT and the market expects inflows of US$70 bln, versus US$75.1 bln in June.