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Dollar/Yen Rally Concluded

After posting its longest wining weekly run since Q4-2001-Q1 2002 to a 26-month high, USD/JPY is set for what appears to be a topping pattern, which will pave the way for an extended pull back towards 115 by month-end and 112 by end of Jan.

Tuesday's trade deal between the US and China over the quantity of allowable US textile imports from China could pave the way for a yuan revaluation against the dollar by Beijing later this year.

The deal will limit the growth of US imports of various clothing to 5.5%, 7.8% and 10.3% in 2006, 2007 and 2008 respectively, compared to 7.5% annually under the safeguard mechanism imposed 4 years ago. The permitted growth rates in other categories would range from 10 to 12% in 2006, 12-15% in 2007 and 15-16% in 2008. These numbers are far less than those demanded by China earlier when it sought growth rates of 20-30% to be levied into 2007.

It can be argued that since the figures in the trade Agreement seem less than those originally sought by China, chances of a yuan revaluation are seen relatively tempered because Beijing has compromised more than it was expected. Nonetheless, it can be argued that the longer time horizon of the import limits can allay any trade frictions and shift the discussion back to a yuan revaluation. Pres Bush's trip to China next week may lead to a revaluation later this month as part of the orders of things to come between Washington and Beijing. This is especially after China's Q3 GDP (released 3 weeks ago) surged to higher than expected 9.5% growth rate. Recall that the revaluation of last July occurred after a faster than expected Q2 GDP release a week earlier. In October 2004, China raised interest rates about 2 weeks following a strong Q3 GDP 2004. Thus, the same may occur this time, with China producing a token gesture of 2.0% revaluation later this month.

The 0.9% y/y increase in Japanese bank lending in October was the third monthly increase, signaling solid prospects for bank lending, following a 0.4% and 0.1% rise in Sep and Aug respectively.

Finally, although the high yield differential story underpinning the USDJPY remains the prime booster in the pair as Japanese institutions find it costly to hedge their foreign outflows, the latest 48 hours have seen gradual dollar retreat amid cautiousness of carry trade unwinding. We have seen how the USDJPY plunged in autumn 1998, summer 1999 and spring 2002 due to carry trade repatriations into the Japanese currency. Although the Bank of Japan has made it clear it would transition smoothly from reduced quantitative easing into interest rate hikes, markets allow the BoJ the benefit of the doubt especially amid the extent of upside inflation.

Japanese bond flows overseas - the primary force behind the yen's decline are starting to taper off. After peaking to 1.8 trillion yen in the week of June 20, net bond outflows have drifted to the 6 billion range in the past two weeks.

We see the pair to have largely peaked and now faces interim support at 116.90, followed by 116.50 - the 50% retracement of the rise from 114.60 to the 118.37 high. Short term bounces seem capped at 117.50.

Best,

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