Trends can persist in currency markets as the macro-economic forces that tend to dominate currency values are typically slow to change. Thanks to stubbornly accommodative monetary policy from the Bank of Japan, a widening interest rate differential between the Japanese yen (NYSEARCA:FXY) and other major currencies, especially the U.S. dollar (UUP), has created one of the most profitable currency trends of the year. While the trend remains a friend, bullish catalysts have finally arrived to turn the tide in the yen’s favor.
In an attempt to have its cake and eat it too, the BoJ intervened in currency markets to slow or even stop the bleeding in the yen. The news hit the wires soon after the BoJ once again refused to budge off its negative interest rate policy. The statement on monetary policy includes a note of confidence from the Bank of Japan (emphasis mine):
“Japan’s economy is likely to recover, with the impact of COVID-19 and supply-side constraints waning, although it is expected to be under downward pressure stemming from a rise in commodity prices due to factors such as the situation surrounding Ukraine. Thereafter, as a virtuous cycle from income to spending intensifies gradually, Japan’s economy is projected to continue growing at a pace above its potential growth rate.”
The BoJ has cruised with its accommodative policy because of low inflationary pressures in Japan. However, the rapid devaluation of the yen threatens to upset the otherwise placid inflationary waters. So, on the surface, the intervention by the BoJ makes sense with the USD/JPY tapping highs last seen in 1998. At that time, the Asian financial crisis was battering the yen. The U.S. cooperated with the BoJ to support the yen as part of the response to the crisis. This time around, authorities have remained silent on cooperation and who knew what and when. Regardless, from even a purely technical level, I would expect the Asian financial crisis highs for USD/JPY to provide at least psychological resistance.
For now, the BoJ has some room to maneuver to prevent a disastrous breakout (on USD/JPY) to perhaps levels last seen in early 1990. The BoJ holds plenty of dollars to sell against the yen. Bloomberg reported that the Bank of Japan has over $110B sitting in the Federal Reserve’s Foreign and International Monetary Authorities repo pool. Japan also has a reported $1.33T in total foreign reserves. Given the lack of details surrounding the intervention, I have to assume the BoJ is preparing for an extended battle and holds plenty of ammunition to keep fighting against traders who dare to lean against the central bank’s wishes. I also suspect a surprise rate hike is in the cards to deliver a coup de grace on the yen’s weakness. A sudden break in policy might be enough to put in a sustained floor on the yen without the BoJ needing to join its peers in aggressive tightening.
The Looming Global Recession
The Japanese yen’s status as a “safety currency” will also work in its favor as a looming global recession becomes more and more real. The Bank of Japan’s peers have barreled along with aggressive rate hikes under the stated calculation that they know exactly how high to go without triggering recessions (can anyone spell “soft landing”?). Given the low odds of success, I see the Japanese yen becoming more and more popular next year as economic weakness becomes more and more real. I am not making an economic forecast. Instead, I am betting that the fog of uncertainty surrounding central bank outcomes will resolve contrary to optimistic expectations. In other words, I am speculating the distribution curve of outcomes does not favor central banks. The Japanese yen should look at least marginally better to traders in a global economic recession.
The Carry Trade Comes to An End
The Japanese yen is acting as a fantastic currency for carry trades. In carry trades, traders sell a low yielding currency to buy a higher yielding one to profit from the gap in interest rates. Traders may also take the proceeds to fund investments in higher yielding assets like stocks. Traders also anticipate that the lower yielding currency will continue to weaken given the differential and provide a sufficient runway for the overall strategy to work. The Bank of Japan has obliged these trades by falling further and further behind its peers. However, the risk involved in chasing that yield increases rapidly as economic outcomes weaken. To the extent carry trades are still active, I expect the reversal of these carry trades to provide one more bullish catalyst for the Japanese yen.
Trading against the trend is always fraught with peril no matter how strong the contrarian catalysts look. If I am correct about the catalysts, I see upside for FXY at least back to its downtrending 200-day moving average (the blue line in the chart above). Such a move represents at least 10% upside. I estimate the downside risks to be about 10% as well with a move back to the early 1990 levels I mentioned earlier. However, traders can limit that downside risk by stopping out at a new all-time low on FXY resulting in an approximate 1.5% loss. In that scenario, I would wait to resume this trade until either 1) FXY approaches another 10% loss with NEW bullish catalysts, and/or 2) FXY closes over 66 again.
Be careful out there!