Trends can persist in currency markets, as the macroeconomic forces that tend to dominate currency values are generally slow to change. Thanks to the Bank of Japan’s stubbornly accommodative monetary policy, a growing interest rate differential between the Japanese yen (NYSEARCA:FXY) and other major currencies, especially the US dollar (UUP), created one of the most profitable money trends of the year. While the trend remains a friend, bullish catalysts have finally arrived to turn the tide in favor of the yen.
In an attempt to have its cake and eat it too, the BoJ intervened in the currency markets to slow or even stop the yen’s hemorrhage. The news caught on shortly after the BoJ again refused to back down from its negative interest rate policy. The monetary policy statement includes a note of confidence from the Bank of Japan (emphasis mine):
“The Japanese economy is expected to recover, with the impact of COVID-19 and supply-side constraints easing, although it is expected to come under downward pressure from higher commodity prices. first due to factors such as the situation surrounding Ukraine. as the virtuous cycle from income to expenditure gradually intensifies, the Japanese economy is expected to continue to grow at a rate above its potential growth rate.”
The BoJ conducted its accommodative policy due to weak inflationary pressures in Japan. However, the rapid devaluation of the yen threatens to upset the otherwise placid inflationary waters. So on the face of it, BoJ intervention makes sense with USD/JPY last reaching highs in 1998. At that time, the Asian financial crisis was beating the yen. The United States cooperated with the BoJ to support the yen as part of the crisis response. This time, the authorities remained silent on cooperation and who knew what and when. Anyway, even from a purely technical level, I would expect the Asian Financial Crisis highs for USD/JPY to provide at least some psychological resistance.
For now, the BoJ has some leeway to prevent a disastrous breakout (on USD/JPY) at perhaps levels last seen in early 1990. The BoJ is holding a lot of dollars to sell against the yen. Bloomberg reported that the Bank of Japan held more than $110 billion in the Federal Reserve’s foreign and international monetary authority repo pool. Japan also declared $1.33 billion in total foreign exchange reserves. Given the lack of details surrounding the intervention, I have to assume that the BoJ is preparing for a protracted battle and holds plenty of ammunition to continue fighting against traders who dare to press against the wishes of the central bank. I also suspect that a surprise rate hike is in the cards to deal a knockout blow to yen weakness. A sudden break in policy could be enough to put a durable floor on the yen without the BoJ needing to join its peers in aggressive tightening.
The impending global recession
The status of the Japanese yen as a “safety currency” will also work in its favor as a looming global recession becomes increasingly real. Bank of Japan peers have launched aggressive rate hikes on the stated calculation that they know exactly how far to go without triggering a recession (can someone spell “soft landing”?). Given the low odds of success, I see the Japanese yen becoming more popular next year as economic weakness becomes more real. I do not make economic forecasts. Instead, I bet the fog of uncertainty surrounding central bank earnings will lift contrary to optimistic expectations. In other words, I assume that the earnings distribution curve does not favor central banks. The Japanese Yen should be at least marginally better for traders in a global economic downturn.
The carry trade is coming to an end
The Japanese yen acts as a fantastic currency for carry trades. In carry trades, traders sell a low-yielding currency to buy a higher-yielding one to take advantage of the interest rate differential. Traders can also use the proceeds to fund investments in higher yielding assets like stocks. Traders also anticipate that the low-yielding currency will continue to weaken given the differential and provide ample runway for the overall strategy to work. The Bank of Japan forced these trades by falling further and further behind its peers. However, the risk of continuing this performance increases rapidly as economic results weaken. To the extent that the carry trades are still active, I expect the reversal of these carry trades to provide further bullish catalyst for the Japanese Yen.
Trading against the trend is always fraught with pitfalls, no matter how strong the contrarian catalysts are. If I’m right about the catalysts, I see an upside for FXY to at least get back to its downside 200-day moving average (the blue line in the chart above). Such a move represents at least a 10% upside. I estimate downside risks are also around 10% with a return to the early 1990s levels I mentioned earlier. However, traders can limit this downside risk by stopping at a new all-time low on FXY, resulting in a loss of around 1.5%. In this 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 above 66 again.
Be careful there!