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US Dollar Likely Set Bottom vs Yen on Sentiment – What Would Confirm?

By , Quantitative Strategist
21 August 2012 20:00 GMT

Retail Forex Trading Crowd Sentiment Pulls Back from Extremes

us_dollar_bottom_japanese_yen_treasury_yields_body_Picture_1.png, US Dollar Likely Set Bottom vs Yen on Sentiment – What Would Confirm?

If SSI ratio (rhs) is negative, it represents the number of traders short for every one long. If it is positive, it is the number of traders long per every short. For a full explanation of the SSI, see our FXCM Expo presentation.

Retail crowd sentiment hit its most bullish USDJPY since the pair traded to record-lows in February, and such one-sided positioning has often coincided with lasting bottoms.

According to FXCM Execution Desk data, there were as many as 15 retail traders long the US Dollar against the Japanese Yen for every one that was short. As of time of writing, that ratio has fallen to 3.6:1—its least net-long since the USDJPY set a noteworthy top in June.

The sharp turnaround in retail sentiment warns of a lasting bottom, and indeed professional options traders are positioned for similar moves in the USDJPY.

FX Options Traders are Near their Most Bullish USDJPY on Record

us_dollar_bottom_japanese_yen_treasury_yields_body_Picture_2.png, US Dollar Likely Set Bottom vs Yen on Sentiment – What Would Confirm?

FX Options risk reversals continue to show that traders are their most bullish the US Dollar against the Japanese yen on record, and the clear divergence warns that few remain positioned for fresh USDJPY lows.

Yet the ultimate determining factor on whether the USDJPY has truly set a bottom may be the trajectory in US Treasury Yields as correlations to the Japanese Yen trade near record strength.

Correlation between US Dollar/Japanese Yen Exchange Rate and 2-Year US Treasury Yield

us_dollar_bottom_japanese_yen_treasury_yields_body_Picture_3.png, US Dollar Likely Set Bottom vs Yen on Sentiment – What Would Confirm?

US Dollar/Japanese Yen Exchange Rate (lhs)

2-Year US Treasury YIeld (rhs)

Correlation between USDJPY and 2-Yr Treasury Yield

A surge in US Treasury yields has coincided with a similar bounce in the US Dollar against the Japanese Yen, and a larger reversal in government bonds would likely support a larger USDJPY rally.

The Japanese Yen remains the most interest rate-sensitive currency of the G10 according to our correlation studies, and we expect the USDJPY to continue tracking moves in US yields.

Several weeks ago we wrote that the USDJPY was likely setting an important bottom on extremely one-sided retail trader positioning and FX Options sentiment, and indeed current readings support our earlier forecasts.

Retail Forex and Options Point to USDJPY Bottom – Can Treasury Yields Continue Higher?

We believe that retail forex sentiment and FX Options markets point to a USDJPY bottom. Yet the clear link between the Yen and US Treasury yields suggests that bonds will need to continue lower (yields higher) in order for the USDJPY to continue its recent reversal.

us_dollar_bottom_japanese_yen_treasury_yields_body_Picture_4.png, US Dollar Likely Set Bottom vs Yen on Sentiment – What Would Confirm?

The 10-Year US Treasury Yield trades at critical price resistance at its 200-day Simple Moving Average. Technical traders often use the 200-day SMA as a gauge of trend; if price breaks above, we might consider that yields have reversed within their long-term downtrend.

We were admittedly caught on the wrong side of the trade when we claimed the US 10-year Treasury marked a massive turn in trend in March on a similar break above its 200-day SMA. There’s obviously risk that we could see a similar pullback this time around.

Yet a key difference is that the 20-day Rate of Change (ROC) in 10-year Yields is at its highest since at least the 1970’s. In other words, yields have surged at their fastest pace on record through the past month.

Periods of extreme volatility can often mark important tops and bottoms, and that key difference leads us to believe that Treasury Yields and the USDJPY may be at a critical turning point as both set lasting bottoms.

Forex Correlations Summary

View forex correlations to the Dow Jones Industrial Average, Crude Oil Futures prices, US S&P 500 Volatility Index, UK FTSE 100, and Spot Gold prices.

Dow Jones

EURUSD

GBPUSD

USDJPY

AUDUSD

USDCAD

NZDUSD

USDOLLAR

1 Week

0.31

0.30

0.45

-0.20

-0.07

0.19

0.01

1 Month

0.70

0.77

0.37

0.71

-0.81

0.76

-0.74

3 Month

0.61

0.69

0.23

0.77

-0.85

0.75

-0.73

1 Year

0.68

0.61

-0.01

0.82

-0.82

0.75

-0.73

Crude Oil

EURUSD

GBPUSD

USDJPY

AUDUSD

USDCAD

NZDUSD

USDOLLAR

1 Week

0.61

0.65

0.40

0.41

-0.63

0.57

-0.42

1 Month

0.55

0.50

0.51

0.53

-0.63

0.52

-0.49

3 Month

0.61

0.59

0.27

0.65

-0.80

0.58

-0.65

1 Year

0.45

0.40

0.10

0.59

-0.60

0.53

-0.51

VIX

EURUSD

GBPUSD

USDJPY

AUDUSD

USDCAD

NZDUSD

USDOLLAR

1 Week

-0.04

0.07

-0.01

0.29

-0.16

-0.25

-0.12

1 Month

-0.53

-0.58

-0.20

-0.51

0.54

-0.67

0.56

3 Month

-0.49

-0.57

-0.28

-0.70

0.68

-0.70

0.60

1 Year

-0.61

-0.54

-0.01

-0.70

0.69

-0.66

0.64

US 2Yr Yield

EURUSD

GBPUSD

USDJPY

AUDUSD

USDCAD

NZDUSD

USDOLLAR

1 Week

0.01

0.29

0.63

0.32

-0.62

0.11

-0.05

1 Month

0.23

0.20

0.64

0.09

-0.26

0.10

-0.06

3 Month

0.33

0.20

0.54

0.31

-0.39

0.25

-0.18

1 Year

0.24

0.12

0.12

0.08

-0.21

0.05

-0.12

Gold

EURUSD

GBPUSD

USDJPY

AUDUSD

USDCAD

NZDUSD

USDOLLAR

1 Week

0.79

0.77

-0.46

0.62

-0.55

0.93

-0.79

1 Month

0.66

0.63

0.00

0.70

-0.73

0.62

-0.75

3 Month

0.54

0.36

-0.12

0.41

-0.37

0.44

-0.54

1 Year

0.32

0.27

-0.19

0.39

-0.29

0.42

-0.42

Perfect Positive Correlation:

1.00

Perfect Negative Correlation:

-1.00

--- Written by David Rodriguez, Quantitative Strategist for DailyFX.com

Meet the DailyFX team in Las Vegas at the annual FXCM Traders Expo, November 2-4, 2012 at the Rio All Suite Hotel & Casino. For additional information regarding the schedule, workshops and accommodations, visit the FXCM Trading Expo website.

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21 August 2012 20:00 GMT