Fundamental Forecast for Japanese Yen: Bullish
- Yen crosses correlation to S&P 500 collapse – which is the better bellwether for sentiment
- Last week’s data allows for the BoJ to maintain a wait-and-see, but time is running out
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The Japanese yen put in for a mixed performance this past week versus its major counterparts. Yet, such a performance is much more disconcerting than the benign picture it seems to put on. While USDJPY, EURJPY and other key crosses were developing ranges, the speculative benchmark S&P 500 has forged new record highs. Is this a sign that yen’s steady depreciation (crosses advance) has hit a ceiling or is this a reflection on the quality of risk trends? It is likely a mixture of both, and that doesn’t bode well for bulls.
Over a longer period of time (60 trading days or 3 months), USDJPY has fostered an exceptionally strong 0.72 correlation to one of the market’s favored – or at least bombastic – measures of risk appetite trends: the S&P 500. Intuitively, that makes sense. In the traditional portfolio, equities represent the higher return asset that investors overweight in ‘good’ times. And, over years of playing the role of a funding currency for the carry trade (the currency we borrow in), the yen has played a similar role in FX where pairs like AUDJPY advance when the market is seeking greater exposure and yield.
Yet, the yen crosses relationship to risk is now proving a source of discord. Turning down the time frame, we find the two-week (10-day) correlation between USDJPY and the S&P 500 has dropped from over 0.90 (exceptionally strong) in the first half of month to -0.28 through Friday. Is this a reflection of the Bank of Japan and Japanese government losing their control over the steady depreciation of their currency? In recent months, we have seen data improve and officials back off of their verbal threats of more stimulus. While that might be encouraging for domestic investment, it curbs speculators’ appetite for the yen crosses. If the BoJ is not committing itself to a depreciation of the local currency, the argument for a long position has to be made on either a strong risk appetite or expectations for growing yield differentials – both factors of the carry trade.
In terms of yields and yield growth, the outlook looks rather bleak. Benchmark lending rates across the developed world are still at record lows while aggregate market-based yields (from their 10-year government bonds) are still extremely depressed – far below mere cyclical lows. This means that there is little carry to be had historically speaking…and yet, the yen crosses are still 20-40 percent off of their record lows. That makes for fundamentally ‘expensive’ positions without an active participation by the central bank to maintain the momentum behind moral hazard and speculative front-running.
Six months ago, the prevailing forecast was for the central bank to upgrade its open stimulus program around one of the April meetings to coincide with the fiscal year end and the implementation of the sales tax hike. Yet shaky growth-based data, rising inflation (CPI) figures and tepid wage growth measures have given policymakers reason to rethink their QE efforts and traders to doubt their reliance.
The best way to reengage the yen crosses is through risk trends. However, we are not currently experiencing the ‘risk on’ sentiment that the S&P 500 seems to point to. Global equity indexes are trailing this move with the Nikkei 225 notably struggling with 15,000. Meanwhile, the emerging markets, high yield assets and other naturally sensitive asset classes are breaking stride with the US equity market. Of course, if conviction were to solidify in appetite for yield, the yen crosses could be urged to rally. Yet, the level of exposure, leverage, fundamental balance and now doubt says the more volatile scenario would be one where the yen crosses collapse alongside risk. - JK