Currency trading markets are likely to see extensive volatility in the week ahead, as forex speculators are largely unsure of what to expect from the weekend’s G7 summit in Washington DC. The event has historically forced extensive moves in the Japanese Yen and other major currencies, and this particular meeting should be no exception. Indeed, extended weakness in the Japanese Yen and the US dollar may produce a fairly significant shift in text regarding currency policies among the world’s Financial Ministers. The trade-weighted US Dollar index now remains at its lowest levels in nearly three decades, depreciating nearly five percent since the April G7 summit. The Japanese Yen remains similarly weak, and high-profile comments regarding Asian currencies are likely to make their way into the official statement from the G7 meeting.
The chart below plots the extreme movements in the Japanese Yen following the past three years of G7 events.
As we can see in the diagram above, there have been very significant market turns surrounding official G7 statements. One of the more notable price movements came in December, 2005, when the G7 statement made explicit reference to the hope that the Chinese Yuan would continue to appreciate against world currencies. This forced the USDJPY over 500 points lower in 30 days and marked a medium-term turn in Yen sentiment. A similarly pronounced tumble came on the following meeting in April, 2006; unchanged rhetoric following sharp Yen appreciation gave traders the green light to continue sending the USDJPY lower. The similar price reactions highlight an important dynamic in the market’s reactions to such communiqués: the lack of change can be just as market-moving as any notable shifts in rhetoric.
What Can we Expect from the G7?
Markets are unsure of what to expect out of the high-profile meeting, with many analysts split on what Finance Ministers will say on recent currency market developments. On the one hand, many argue that recent official commentary on exchange rates will not be enough to sway all G7 Financial Ministers and produce a notable shift in the accompanying summit text. Proponents of such arguments claim that pressure from European politicians will be unable to convince US and Japanese officials that such rhetoric shifts are in their best interests. Indeed, Japanese Financial Minister Fukushiro Nukaga is well-aware that specific reference to the Yen will cause excessively volatile appreciation in the currency.
Unchanged text on foreign currencies in the official G7 statement would almost undoubtedly cause an instantaneous Japanese Yen and US dollar tumble, with continued focus on revaluation of the Chinese Yuan the most likely outcome. Though this was enough to cause a significant USDJPY tumble in December, 2005, markets have grown increasingly accustomed to narrowed G7 focus on China’s forex policies.
Yet some analysts believe that European finance officials will be able to sway their US counterparts if they agree to increase pressure on China and Japan to allow for currency appreciation. US domestic pressures have left weakness of the Chinese Yuan and the Japanese Yen as very important political issues for the coming election year. If this is enough to force European and American cooperation on the Yen and Remnibi, we may see relatively significant commentary on US dollar weakness.
Any specific reference to the Japanese Yen and US dollar would very likely cause a sharp USD and JPY appreciation. This would be most easily seen in euro pairs, with the EURUSD and EURJPY likely to tumble in the wake of such a significant political shift. Worries that this may occur have kept these currencies depressed through mid-week trade, and we are unlikely to see significant EURUSD or EURJPY gains ahead of the key result.
How Could we Trade the G7 Statement?
Previous experience has shown that G7 statements have brought significant trend reversals or continuations for USD and JPY pairs. These dynamics leave us with several trading scenarios on different outcomes in the meeting’s communiqué.
Likely scenario: Exchange rate commentary remains largely unchanged, with a specific mention of Chinese currency policy the only explicit mention in the G7 statement.
This outcome would likely bring sustained USD and JPY losses, with the best trading opportunities seen by selling the USD and JPY against the euro, Canadian dollar, British pound and other strong trending currencies.
Less likely scenario: Exchange rate commentary makes specific reference to US dollar and Japanese Yen weakness, with comments on China’s forex policy unchanged.
This outcome would cause the opposite effect, forcing medium term USD and JPY appreciation. The best trading opportunities would be found in buying the US and Japanese currencies against previously high-flying counterparts—namely the euro, British pound, Canadian dollar and other previously strong currencies.
The Wildcard: G7 statement sees a completely changed paragraph on foreign currencies, with specific reference to cooperation in forex market intervention to prevent further US dollar and Japanese Yen declines.
This is the least likely outcome, but it nonetheless represents the biggest risk to traders holding US dollar shorts and/or long carry trade exposure. Group of 7 leaders last agreed to forex market intervention in 2000, when extended euro weakness encouraged sovereign buying of the single currency against major counterparts. The effect on exchange rates was immediate, and it forced a very stable longer-term bottom in the EURUSD. A pledge to intervene and buy US dollars and/or Japanese Yen would instantly force the opposite effect in currency pairs. The best trading opportunities would likely be found in buying USD and JPY against previously strong counterparts.
Written by David Rodríguez, Currency Analyst for DailyFX.com