While the release of economic indicators, interest rate decisions, and comments by global central bankers tends to spark volatility in the forex markets, there is one phrase to describe the key driver of significant directional moves: risk trends. Indeed, in recent months, sentiment amongst traders has been prone to major periods of risk aversion and flight-to-safety as a credit crunch and financial instability spreads throughout the global markets. While these problems were ultimately triggered by the collapse of the US housing market, the impact of shifts in risk appetite in the forex markets has not been contained to just the US dollar.
In fact, the Japanese yen pairs have served as the best gauge of risk sentiment. With an interest rate of only 0.50 percent, the Japanese yen is sold off en masse during times of low volatility, and bought up quickly when equities fall sharply as traders seek to avoid the market’s riskiest assets.
While the Japanese yen has fallen lower over the past few weeks, the currency is still up almost 15 percent against the US dollar since early August 2007 while the Dow Jones Industrial Average has lost over 8 percent during the same period. As Currency Analyst John Kicklighter discussed in a special report recently, currencies can be used to time equity moves. So what’s next for the Japanese yen? Furthermore, what does that tell us about equities and more importantly, risk appetite in the markets?
Rocky Financial Markets and Dour Economic Data Doesn’t Bode Well for Risk Appetite
From a fundamental standpoint, the outlook for risk sentiment in the markets appears to be anything but bullish for the USD/JPY pair and the DJIA. First, the US credit markets remain tight, as DJ credit default swaps, credit card delinquencies, and mortgage delinquencies have all risen as Moody’s announced it had cut major bond insurer FGIC’s credit rating to a level just above junk. Rumors have been circulating that Fed strategists have been looking into the viability of nationalizing banks, as Norway, Sweden, and Finland did in the early 1990’s. (For more, see our most recent Watch What the Fed Watches report). Furthermore, outside of the US, Swiss-based UBS – the world’s largest money manager – disclosed the biggest write downs on securities debt of any bank to date.
Meanwhile, in his testimony to the Joint Economic Committee on Wednesday, Federal Reserve Chairman Ben Bernanke was bearish on the US economy in the first half of 2008, noting that growth may “contract slightly” as prospects abroad have “diminished somewhat” while domestic homebuilding activity would continue to drop in “coming quarters.” Though there are substantial upside risks to price stability in the near-term, Bernanke noted that he expected inflation to moderate eventually, suggesting that the FOMC has been given the green light to continue cutting rates. While the FOMC is unlikely to cut as aggressively as they did in January (125bps) and March (75bps), fed fund futures are fully pricing in a 25bp reduction on April 30, which does not bode well for the US dollar, especially against the Japanese yen.
This is a chart that we have shown many times. It is the monthly chart of the USDJPY since the early 1970s. A picture perfect 5 wave decline appears to be unfolding from the 1971 high in the USDJPY. Wave 3 of the decline was extended and divides perfectly into 5 waves itself. Wave 2 was a sharp zigzag correction and wave 4 a triangle (a-b-c-d-e); which satisfies the guideline of alternation (if wave 2 is sharp, then wave 4 should be shallow and vice versa). If this pattern is correct, then wave 5 is underway now and would not be considered complete until the USDJPY drops below 81.12.
Obviously, we need to look shorter term in order to time the trade. The most recent leg of the decline is a 5 wave drop from 108.59. A 3 wave correction is underway now and will probably end near 104. 103.88 is where wave C of the corrective rally would equal wave A and the 61.8% of 108.59-95.72 is at 103.67. Both levels are in the vicinity of wave 4 of one less degree (it is common for corrections to end near the 4th wave of one less degree). In summary, resistance should be strong in the 103.70/104.00 area. The longer term bearish count remains on track as long as price is below 108.59.
The Dow and USDJPY have exhibited a high positive correlation over recent months and the current pattern in the Dow confirms what we are seeing in the USDJPY. Since the top at 14,198 in October, the Dow has traced out an impulsive decline, corrective advance, and impulsive decline. A second corrective advance is underway now and resistance is strong in the 12,860-12,960 zone. A rally to this level would complete a series of 1st and 2nd waves and give way to a 3rd of a 3rd wave decline. 12,860 is where wave Y would equal wave W (the rally from 11,640 is a complex correction and is labeled W-X-Y). 12,960 is the 61.8% of 13,777-11,640. Potential trendline resistance defends the 12,860-12,960 zone as well.
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Written by Terri Belkas, Currency Analyst, and Jamie Saettele, Technical Strategist of Forex Capital Markets LLC, DailyFX.com[B][I]
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