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For the first time since early June, 3-month dollar calls are trading at a premium over puts (25 delta). Calls were trading at a shrinking discount since early October, but has only turned positive last week. The latest push took place in a rising volatility environment. Three-month implied volatility rose from about 8.5% on October 29 to about 10.3% yesterday. Putting these two things together suggest the market has been buying dollar calls in anticipation of a upside breakout for the greenback.

This was also reflected in a nearly 15% rise in gross short yen futures positions at the CME to their highest level in a month, for the most recent reporting week. The underlying view appears to be that while the Fed is likely to taper, some, though not ourselves, think tapering is likely in December. Meanwhile, nearly three-quarters of the respondents in a Bloomberg poll expect the BOJ to step up its stimulus efforts to increase the likelihood of reaching its 2% inflation target. Between late October and yesterday, the 10-year U.S.-Japan interest rate differential widened from just below 190 bp to almost 220 bp.

This is roughly where the 10-year spread peaked in September, which was itself a 2-year high. The spread is a few basis points lower today. Implied 3-month volatility is also lower (by about 0.5%). The dollar has been turned back from the June-Sept (and now Nov) trend line.

Market positioning may be getting ahead of itself in playing for the breakout. Even if the dollar breaks above the trend line, which comes in just below JPY100, there is likely to be additional resistance near the September high near JPY100.60. The 60-day correlation between US Treasuries and the dollar-yen is near 0.62 (whether one conducts the study on the basis of level or percentage change, though in terms of the latter this is roughly the year's high). In some ways, then the outlook for the dollar-yen is a function of U.S. 10-year yields. We suspect that the 2.80% that was approached yesterday represents not only the 61.8% retracement of the decline on the Fed's failure to taper in September, but likely is the upper end of yields for the coming weeks.

This also corresponds to our expectation that ahead of the capital gains increase on Jan 1 (from 10% to 20%) that Japanese investors are likely to take profits on the heady gains seen in the stock market this year. The Nikkei and Topix are up about 40% year-to-date, while the JASDAQ is up about 68.5%.

Foreign investors have purchased about $108 bln of Japanese shares here in 2013. Some may also take profits. However, anecdotal reports and the popularity of ETFs, such as DXJ, which hedge the currency risk suggests foreign sales of Japanese equities may not be bearish the yen, as one might intuitively suspect.

Source: What The Options Market May Be Telling Us About The Yen