The Japanese Yen saw a clear reversal of fortunes in the second quarter, as the previous darling of tumultuous financial markets lost ground when global turmoil began to ease. The low-yielding currency had previously rallied strongly on what was a clear de-leveraging across risky asset classes, but a return to risk appetite allowed forex traders to cautiously re-enter historically profitable carry trades. In Q2 of 2008 financial market conditions made the Japanese Yen trade almost completely correlated to the movements in the Nikkei 225 and US Dow Jones Industrials Average—leaving domestic economic developments relatively unnoticed through recent trading. Indeed, Japanese Yen traders remain almost oblivious to fundamental data out of the world’s second-largest economy, and such a trend will likely continue into the third quarter. The outlook for the yen will thus depend almost exclusively on the outlook for the broader global financial markets.
[B]Risk Appetite will Drive the Japanese Yen in the Second Half of 2008[/B]
Whether or not the carry trade can continue to recover arguably remains the most important question in our outlook for the Japanese Yen. Given exceedingly low domestic interest rates, investors will often sell Japanese Yen to buy higher-yielding counterparts and collect the rate differential. These typically highly-leveraged trades will work best when the Yen remains stable or actually depreciates versus said counterparts; if the Yen appreciates rapidly, capital losses in said trades will far outweigh the interest rate payments collected through the short term. The combination of leverage and aversion to sharp price moves makes the JPY-funded carry trade especially sensitive to market risk appetite; a sudden jump in risk aversion will typically force traders to liquidate short positions in the Japanese Yen. In the graph below we see the clear effect of market volatility on the Yen: the JPY has moved nearly in lockstep with our DailyFX Currency Volatility Index. Thus we see reasons why the Japanese Yen, and by extension the carry trade, remain very highly sensitive to broader market risk appetite.
[B]What Can we Expect out of Risk Appetite and the Carry Trade?[/B]
Market conditions can change in an instant, but it seems as though elevated risk aversion and general financial market duress may be here to stay for the foreseeable future. Already we see that major world equity markets—bellwethers for investor optimism—have almost uniformly fallen through the second quarter of the year. What started as an upheaval in US mortgage market has ballooned into a worldwide credit market crunch, and few global financial centers have been left untouched. Various credit indicators actually improved through the second quarter of the year, but a more recent deterioration could actually signal continued duress in global markets. Credit Default Swaps, the cost of protection against default in various debt instruments, fell consistently through mid-May after peaking in March. More recently, we see that the Dow Jones CDS Index has risen significantly from May lows, and the global investors are paying more and more to protect themselves against credit risk across a broad swath of corporate debt instruments. Given system-wide fears of credit default, it seems unlikely that risk appetite can make a significant comeback through the foreseeable future.
Options traders have likewise positioned themselves for further market duress, and demand for Japanese Yen Call options (USDJPY Puts) has dominated trading. A long-term DailyFX study of USDJPY options shows that the Japanese Yen tends to appreciate rapidly when Risk Reversals—the difference between prices paid for out of the money Puts and Calls—fall below -2 percentage points. Options prices did just that at the beginning of the carry trade unwind when the USDJPY traded at 120 and have not turned back since. A look at futures positioning from the CFTC’s Commitment of Traders report shows a similar story in regards to the yen.
Net positioning has unsurprisingly grown more bearish against the Japanese Yen (bullish the USDJPY) through the past quarter of clear depreciation, but increased complacency could nonetheless signal the start of a fresh Japanese Yen rally. When the entire market begins to lean towards the same side of a trade, there is relatively little scope for further price moves in that direction. We saw this dynamic play out many times through the past several years of yen price action, with extreme JPY-short positioning (USDJPY long) preceding impressive yen appreciation. The most recent example of said dynamic came in December, 2007, when net USDJPY positioning rose just below net-long territory. Given a strongly bearish overall trend, the buildup in USDJPY longs provided plenty of fodder for a subsequent unwind and USDJPY tumble. Of course, there may be certain fundamental hurdles in the way of sharp JPY appreciation.
[B]Bank of Japan one of the few central banks not overly worried about inflation[/B]
The Japanese Yen has historically weakened on a clearly disadvantageous yield differential against major counterparts, and a relatively bearish outlook on rates may signal further losses through the medium term. The Bank of Japan currently boasts the lowest short-term interest rate target of any major world central bank, and a relatively benign outlook for domestic inflation will likely give it room to keep interest rates low for quite some time. Unlike many other world economies, Japan’s yearly inflation rate rests midway within the central bank’s target range. Sky-high global energy prices likewise have comparatively less scope to force significant price gains in Japan; its economy is one of the least energy-dependent of the industrialized world when adjusted per unit of Gross Domestic Product. It is subsequently little surprise to note that markets have priced in practically zero interest rate hikes from the Bank of Japan through the months ahead.
According to Overnight Index Swaps, markets predict that the BoJ will raise its overnight rate by a cumulative 29 basis points through the second half of 2009—a number that pales in comparison to 95bp from the US Federal Reserve and 68 from the European Central Bank. A widening interest rate differential leaves the yen at a further disadvantage against higher-yielding counterparts, and such pressures could lead to further JPY weakness. Already we see that the New Zealand dollar has consistently underperformed on the basis of interest rate expectations. Indeed, the Reserve Bank of New Zealand doomed the Kiwi to swift declines when it explicitly said that it looked to cut interest rates sooner than previously anticipated through the coming months. Overnight Index Swaps now show forecasts of a whopping 125 basis points in interest rate cuts from the NZ central bank, and the New Zealand dollar has traded lower as a result.
It will be important to watch the outlook for the Japanese economy as it relates to the future of domestic interest rates. Though somewhat unlikely, we could see inflationary pressures rapidly accelerate and derail price stability. Such a dynamic would force the Bank of Japan’s hand and bring higher interest rates to the low-yielding yen, but we must likewise keep in mind that the BoJ will likely be slow to move except in the direst of circumstances. Given a fairly recent 7-year period of deflation, Japan is only now seeing CPI changes in positive territory. It can subsequently be argued that the current spike in headline CPI may not translate into a sustained rise in inflation expectations, as a generation of year-over-year price decreases remains ingrained in the psyche of the domestic consumer. Furthermore, the Bank of Japan will be especially reticent to constrain monetary policy in the face of anemic domestic household spending. According to government statisticians, Household Spending has fallen 3.2 percent on a year-over-year basis through May—it’s worst showing in nearly two years. Given these factors, one could easily argue that the Bank of Japan will be slower to raise interest rates than other major central banks. Therefore the Japanese Yen will remain at a continued yield disadvantage against its higher-yielding counterparts.
[B]EURJPY Could Continue to Rise on Hawkish European Central Bank Rate Outlook (To be revised post-ECB)[/B]
Relatively clear expectations for European Central Bank interest rate hikes have significantly boosted the euro’s implied yield advantage against the yen, and the EURJPY has scaled fresh record-highs on the clearly bullish developments. Whether the euro may continue to gain will likely depend on whether the ECB decides to follow through on aggressive market forecasts for the future of the European yield curve; official rhetoric to date has not made it exactly clear that the central bank will raise rates as high as market yields imply. It will be very important to monitor official ECB statements as it relates to the future of domestic yields, as it seems that risks arguably remain to the downside on any disappointments. The same risk sentiment-based pressures that affect the USDJPY likewise threaten to derail EURJPY; any significant flare-up in market turmoil could cause dramatic EURJPY tumbles. Given that the EURJPY fell nearly 1400 pips in just 30 days through the beginning of the subprime crisis, one could easily imagine similar episodes on a recurrence of worldwide financial panic.
[B]What to watch for in the Third Quarter for the Japanese Yen[/B]
Whether or not the Japanese Yen will continue its second quarter decline will almost exclusively depend on outlook for global financial markets, but currency traders will likewise place weight on relevant interest rate outlooks for Japan and other major economies. We saw the Japanese Yen strengthen significantly through the second half of 2007 and the first quarter of 2008 on clear financial market turmoil, but broad improvements in market conditions made the low-yielder the worst performing G10 currency since April. Yet it remains clear that financial markets may not be out of the woods just yet; several key indicators signal persistently low risk appetite across important asset classes. Such a dynamic translates into strong demand for protection against Japanese Yen appreciation; given fears of rapid JPY gains, options traders have kept USDJPY Puts very well bid. All in all, we would argue that risks remain to the upside for the Japanese Yen (downside for USDJPY) through the second quarter, but a number of factors make our JPY outlook far from certain and much will depend on similarly indecisive global markets.
[B][U]USD/JPY Technical Outlook[/U][/B]
[I]By Jamie Saettele[/I]
There is no change to the longer term call for a drop to below 80 but the count from the 124.13 top has changed. The preferred count treats the decline from 124.13 is a leading diagonal. Under this count (and given near term weakness), the entire advance from 95.72 could be a completed wave 2. If so, then wave 3 down is in its early stages. However, it is more likely that the rally from 95.72 completed just wave a of 2. Leading diagonals are typically followed by deep retracements - often as deep as 78.6% of the move. A 78.6% retracement would place a wave 2 top near 118.00. Just a 61.8% retracement places a wave 2 top at 113.30. The expected path of the USDJPY is shown on the chart (down in wave b of 2, then higher and into a top in wave c of 2). The alternate treats the drop from 124.13-95.72 as a W-X-Y decline (7 waves, which is corrective). However, it is not clear where this fits in the larger pattern (take a look at the monthly, and it is quite clear that the USDJPY has broken from a 4th wave bearish triangle).
