A near 800-point reversal from the Japanese yen last week says more about the state of volatility going forward for the currency than its actual direction. The past week was filled with market moving event risk and its influence over general sentiment has altered this carry currency’s bearing.
Fundamental Outlook for Japanese Yen: Bearish
- A 20bp BoJ rate cut does little to cool the yen’s rise or recharge growth - Panic selling breaks and the carry trade rebounds; but conditions still worsening for the carry trade - The Dow posts its second-biggest point gain as the cheapest valuations in two decades tempts investors
A near 800-point reversal from the Japanese yen last week says more about the state of volatility going forward for the currency than its actual direction. The past week was filled with market moving event risk and its influence over general sentiment has altered this carry currency’s bearing. With the US GDP reading and Fed rate decision out of the way, the market has replaced speculation with acceptance; and this has (oddly enough) helped to settle price action. If the world’s largest economy is heading into a recession and reacting to the financial fire with large rate cuts, the pace has been set for the other major policy makers. It is this confirmation that will offer a temporary break from the consistent unwinding of the carry trade and flow of capital to safe havens. Without the perceivable threat of something that may require further speculation about the severity of the global economic slump or the ultimate bottom in lending rates, the market will seek some sense of balance before taking on the risk in trying to drive the yen once again.
However, though volatility may very well settle next week, we should not take this to mean that the carry trade will turn. A look at one-week implied volatility (a good gauge of fear or caution) from USDJPY options is still at 38 percent. To put that into perspective, the average level of volatility over the past year was 14.6 percent. Needless to say, traders are still very wary of the potential for another dramatic increase in price action – and well they should be. The market crash, bank failures, massive bailout plans and sharp moves in the currency market this past month merely hint at the breadth of the financial crisis. In the bigger scheme of things, the credit crunch is likely only in its first phase (and probably not yet through it). With the USDJPY closing the month at 13 year lows, the Nikkei 225 near 26-year lows and the carry trade index at levels not seen since 2003, it is clear that fundamentals are keeping risk appetite depressed. Going forward, the world’s largest economies will begin to confirm their descent into recession. This drop in output will naturally weigh on the cumulative investment base through reduce asset values and investors taking their money out the market. While fundamental interest in other pairs will begin to revolve around how deep an economy’s recession will be and how quickly rates can recover on a relative basis, yen traders will concern themselves with the overall level of growth and volatility throughout the market. This is the case because Japan will emerge from this crisis once again with rates at consistently low levels. This was exactly the case following the rebound from the Asian Financial Crisis. With a long history of deflation, consumers who are net savers and capital that is exported for investment purposes, the yen is stuck in a cycle of being a perpetual funding currency.- JK
Questions? Comments? Send them to John at jkicklighter@dailyfx.com.