The second quarter was a phenomenal time to be short the Japanese Yen. Not only did the Yen fall against the US dollar, but it also dropped to decade and in some cases, multi-decade lows against every major currency.
From the beginning of April to the end of June, USD/JPY rallied over 600 pips with virtually no retracement. However this impressive move pales in comparison to the 1000 point rally in AUD/JPY, the 1200 point rally in NZD/JPY and the 1400 point rally in GBP/JPY. Demand for carry trades was voracious in the second quarter as rising oil prices and strong job growth gave traders the confidence that hawkish monetary policies were here to stay. Although the US housing market continues to be plagued with problems, it?s impact on overall US economic growth has been mild thus far. Unless we have a major write down from a company that is as big as Washington Mutual, traders will probably continue to shrug off the increases in foreclosures and the drop in home sales. Is this lack of concern dangerous? Probably. However with the market hungry for risk, carry trades which includes USD/JPY, will not turn until risk aversion reappears. The Federal Reserve is expected to keep interest rates on hold for the next year. The earliest the market expects the Bank of Japan to raise rates is in the fourth quarter. The 125 level is a natural resistance point for the currency pair. A break above that level could lead to rally up to 135, the January 2002 high. Otherwise a move below 122 sees no major support until 120.
[B]Weak Yen: A Boom for the Economy[/B]
As an export dependent nation, the Japanese economy is extremely sensitive to the value of its exchange rate. The weakness of the Japanese Yen in second quarter should help drive a further recovery in the lethargic economy. Over the past few weeks, we have already seen Japanese companies increase their profit forecasts simply because the Yen has fallen more than they expected. At the end of the second quarter, Japanese tire maker Bridgestone revised its annual net profit up by 18 percent because of exchange rate fluctuations. They were originally looking for flat profits, but the company was calculating its forecasts based upon 110 USD/JPY and 140 EUR/JPY. The Yen has of course weakened much further than those levels (USD/JPY is now trading at 123 while EUR/JPY is trading at 168); a weak Yen is positive for corporate profitability because it boosts the value of repatriated profits on sales conducted abroad. The only time the weak Yen becomes a major problem is when oil prices are rising, like they are now. Japan imports nearly all of its oil and the price of the import will rise as the yen falls. For the time being, these two offsetting factors should keep economic growth steady and whichever factor reverses its trend first will be the more dominant driver of yen fluctuations in the coming months.
[B]But a Concern for Foreign Nations[/B]
At the same time, as the Yen weakens further, global trade tensions will likely escalate. European leaders as well as European corporations have complained loudly about the Yen?s weakness against the Euro for months, but the market has been shrugging off these criticisms because the European Central Bank, which controls currency and monetary policies for the region is not concerned. Only when the US joins the call for yen strength will this issue begin to resonate with the market. According to the latest official data from the World Trade Organization (2005), Japan exports 60 percent more goods to the US than to the European Union. This makes USD/JPY the currency to watch. At 122, US officials are carefully watching the currency?s movements, but they have stopped short of pounding the table for the US government to do something about the yen?s slide like they are doing about the Chinese Yuan. At 125 and above, things may change quickly.
[B]What Does This Mean for the Bank of Japan?[/B]
If the Japanese Yen continues to fall, the government may attempt to reduce speculative demand and prevent international backlash by putting pressure on the Bank of Japan to raise interest rates. The last time the central bank raised interest rates was back in February. They appear to follow an unofficial schedule of raising rates every “every six months” which is characteristic of the usually conservative central bank. The interest rate curve is pricing in another rate hike over the next 2 to 3 months which means they expect the BoJ to raise rates in either September or October. This would be well after the Parliamentary Elections, which means that approval ratings may be less of a priority. In order to not completely catch the market by surprise, the central bank will most likely increase their degree of hawkishness at the August meeting. All of this is in line with their steady as she goes approach to monetary policy. Economic growth has been mixed and inflation almost nonexistent, but at the same time corporate profitability is healthy thanks to a boom in the export sector. In the second quarter, unemployment dropped to a 9 year low which means that at some point, companies will have to increase wages in order to retain their employees. The bottom line is that the economy will be able to handle 25bp of tightening. The bigger question is “will it matter?”
[B]Watch out for Mrs. Watanabe[/B]
A quarter point rate hike would bring the Japan?s interest rate to 0.75 percent, still the lowest in the industrialized world and not enough to cause a mass wave of repatriation. Mrs. Watanabe - Japan?s version of Mrs. Smith, the archetypical housewife has become a major player in the currency market over the past few years, according to some analysts responsible for more than 10% of daily trading volume. She has stepped in to buy every dip in carry trades because the 6 percent plus yields offered abroad are far superior to the 0.5-2 percent yields offered at home. She is not as leveraged as the usual hedge fund which means that she could also be willing to sit far longer with her carry trades than the average speculator. The Yen crosses would need to fall 500-700 points over a very short period of time before she will become worried.
[B]A Case of Seasonality[/B]
Finally, it is important to point out that there is a strong case of seasonality in USD/JPY in the month of August. As many people may know, technical analysis is based upon the study of past price patterns and there is no purer way to look at price patterns than to examine the fluctuations of a currency over a period of time. August is typically the strongest month for the Japanese Yen across the board. The graph below illustrates how USD/JPY has fallen in out 8 of the past 10 years. Part of this may be due to the fact that USD/JPY has an even stronger seasonality effect in the month of July with the currency pair rallying in 9 out of the past 10 years.
The fate of USD/JPY lies in the hands of carry traders. Seasonality tells us that we should have a strong July followed by a weak August. This pattern of price fluctuations is aligned with our belief that the Bank of Japan will signal to the markets that will be raising rates either in September or October. The carry trade is becoming exhausted which puts the odds in favor of a correction in the Yen crosses. However this will only occur IF the market begins to price in a BoJ rate hike or IF the problems in the US housing market exacerbates. Should neither of these scenarios unfold, carry trades could move on to beat even the most optimistic analyst forecasts.
While we were on the completely wrong track last quarter regarding the EURUSD and GBPUSD, the bullish USDJPY outlook has proved correct. The next level of chart resistance is not until the December 2002 high at 125.73. A confluence of Fibonacci measurements suggests that strength will persist until the 128.00 figure. The 78.6% of the 5 wave decline from 135.13-101.67 is at 127.97. The 100% extension of 101.67-121.39/108.98 and the 100% extension of 108.98-122.17/115.14 are at 128.70 and 128.33. Three long term Fibonacci measurements this close to each other is rare. When this does happen, the level in question tends to act as a magnet. As always, the outlook can change as price action dictates. Any change to the longer term structure will be covered on the daily technicals.
[B]USD/JPY Weekly Chart (Source: TradeStation 8.2)[/B]