Fundamental Forecast for Japanese Yen: Neutral
- Yen crosses are looking increasingly expensive with risk trends (Nikkei) struggling and the BoJ backing away from QE upgrades
- USDJPY expected volatility has collapsed to levels not seen since November 15, 2012 – a contrarian reading
- Find signals on the yen crosses using DailyFX-Coded Strategies running on Mirror Trader
Half of the most liquid yen crosses closed out this past week in the green. Though, that should provide long-term bulls little relief. So far in 2014, this once high-flying group is under water. The forces that provided the momentum of 2012 and 2013 – a reach for yield and the introduction of a massive stimulus program from the BoJ – have been sidelined. And now, fear is creeping in that there is a very real risk that speculative appetites are starting to wilt and the central bank is shelving plans to upgrade its QE plans. While neither theme is threatening to collapse – yet – the yen crosses may still topple (yen rally) in the absence of further expansion.
Some markets and themes default to a certain bias. The S&P 500 is a great example whereby it naturally rises in the absence of conflicting fundamental catalysts due to the chase for returns over the last five years. At one point, the yen crosses shared that innate momentum, appreciating off the back of speculative appetite – some see it inversely as a lack of fear – and the afterglow of the Bank of Japan’s (BoJ) sizable stimulus upgrade. Yet, both of these drivers are losing power and it is proving increasingly difficult to connect them to this carry trade. If indeed we are running out of hot air to keep this balloon up, the market will quickly recognize how high we are.
We are currently between 40 and 15 percent above the levels the yen crosses were lurking before the market began its run up in anticipation of the open-ended stimulus program. That is a hefty premium, particularly when we look for a fundamental valuation familiar to these pairs – carry. Whether we use benchmark rates, government bond yields or further-from-prime market returns; we find the ‘carry’ on crosses are still historically low. The deviation between this underlying worth and current market rates is extreme, and an ominous liability. This is especially true when we note the long-standing congestion in pairs like USDJPY or that implied (expected) volatility for the same pair over the coming month has dropped to its lowest level since November 2012. These are potentially explosive conditions of complacency.
A return to trend for the yen crosses would be best accomplished by revitalized risk trends...bullish or bearish. Here there is an imbalance. While we are still riding on a multi-year investment wave, even the long-term bulls are talking saturation and the need for a correction with economic conditions cooling. Risk aversion, on the other hand, taps into conditions of excessive leverage, concentrated exposure and low levels of participation. In other words, a deleveraging could prove violent for capital markets and yen-based carry trades. Yet, this is a risk that has lingered at the fringes rather than fully materializing. We should not lose sight of the threat of risk aversion, but recent history has proven it is costly to try and preempt it.
Where risk aversion would be the most decisive and effective catalyst for resolving this tense, meandering situation; we may find monetary policy the more likely source. In just a few weeks time, the BoJ is expected to hold the first of two policy meetings scheduled for April. This time last year, the central bank introduced its current open-ended stimulus effort. Not long after the program was inducted, speculation of a further increase was priced in. Over the past months, that expectation has deflated significantly. Central bank members have repeatedly voiced confidence that the economy would meet its inflation target and the economic impact of the upcoming tax hike would be transitory. Policy officials are deliberate in their remarks as they acclimate the markets ahead of change. The BoJ’s lean seems clear.
The fundamental prospects for the yen crosses are building pressure rather than shaping progress – in large part because they contradict holdover complacency. A break out – bullish or bearish – from congestion for USDJPY and the other yen crosses is inevitable. But as with anything in trading, success is in the timing. - JK