US Dollar / Japanese Yen (USD/JPY): Will 2007 Be the Breakout Year?

Did you know that in 2006, the Japanese Yen had the tightest range against the US dollar in 35 years? Last year, volatility in the currency market contracted significantly, causing USD/JPY to remain restricted to a 10 big figure (each big figure is 100 pips) trading range. Over the past 35 years, the average high to low range of USD/JPY was approximately 30 big figures or 3000 pips. In 2006, the yearly range was one third of that. Sharp contraction in ranges tends to lead to sharp breakouts and 2007 could be the year in which we see just that.

Plunge in Volatility in 2006 was Driven By Central Bank Activity

Before exploring what could happen in 2007, we need to understand what drove volatilities lower last year. There were 3 main factors that encouraged the drop in volatility – central bank activity in the markets, the predictability of monetary policy and the one-sided action by hedge funds. Central banks have been more active in the currency markets than ever these days. From reserve diversification to worrying about the value of each other’s currencies, government officials have been keeping a close eye on exchange rates. On one hand, central banks such as China and Russia are moving to diversify out of dollar based assets and into the currencies like the Japanese yen and Euro. On the other hand, countries like Japan are doing all they can to limit sharp appreciation in their exchange rates. Central banks became far more transparent about their outlook for monetary policy while narrowing interest rate spreads throughout 2006.

Statistical Significance of Last Year’s Range

The yearly trading range for USD/JPY can be seen in the following chart; the red line denotes the average. In only 4 out of the past 35 years, including 2006 has the range fallen below 50 percent of the average, which are circled in green. In each one of those instances, the trading range increased by more than 35 percent the following year. Just from a statistical perspective, this suggests that we could see a similar rise in volatility in 2007. However that is not the only reason?

Potential Drivers for a Breakout

The New Year is just beginning and the Bank of Japan has already raised interest rates once. Their intentions are to continue to normalize interest rates and it is just a matter of when. If the economic recovery in Japan accelerates, the central bank may be compelled to raise rates sooner rather than later. The market is very short yen at the moment and becoming even more so over the past few days because carry trades remain lucrative. However, these same carry traders are ready bail at any sign of trouble because they know that greater risks lie in the direction of yen strength than weakness. Also, if the yen becomes too weak, Japan runs the risk of being branded a currency manipulator. Therefore, the risk of carry trade unwinding could trigger a sharp rise in the value of the Japanese Yen. On the other hand if the US economy improves and the Federal Reserve is forced to raise rates once again (instead of just contemplating them), we could see sharp all around gains in the US dollar. The key is that USD/JPY tends to be a very trending currency pair, which means that moves can be one directional for a very long period of time.

Technically, the following monthly chart of USD/JPY reveals a very significant breakout in place. A similar sort of breakout happened in 2005 and we saw a move that extended close to 15 big figures over the course of the year. Even if this upside breakout is false, a reversal and corresponding move to the downside could be just as sharp and brutal.