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3 New Trading Scenarios for USD/JPY

3 New Trading Scenarios for USD/JPY

Kathy Lien, Technical Strategist

The Bank of Japan (BoJ) meeting is certain to determine the near-term future for the USDJPY pair, and these are the 3 possible scenarios for traders to consider once the much-anticipated announcement is made.

The time has finally come for the Bank of Japan (BoJ) to deliver. After preparing the market for aggressive monetary easing over the past few months, investors are looking for the central bank to follow through with their promise on Wednesday evening.

This meeting will be a first for BoJ Governor Haruhiko Kuroda, and based on last week's comments, he doesn't plan to keep the BoJ sitting on the their hands for another month. While most investors also expect Japan's central bank to announce new easing measures, the recent rally in the Japanese yen (JPY) suggests that most expect the BoJ to underwhelm.

Kuroda's team has many options at their disposal, and the final announcement can take many forms, but here are 3 basic scenarios that traders should be watching for as a result of the meeting:

Scenario #1: Open-Ended Asset Purchases > Bullish for USD/JPY

The most aggressive announcement that the BoJ can make would be to pull forward their open-ended asset-purchase program from 2014 to May 2013, or better yet, initiate it immediately. By shifting to unlimited quantitative easing (QE), the central bank would prove to the market their level of commitment.

This should go hand-in-hand with an extension of the duration of Japanese Government Bond (JGB) purchases: the further out, the better.

If the bank also increases the amount of risk assets bought beyond JGBs, it would be a perfectly wrapped gift to the economy and the market. Forex traders would most likely respond extremely well, taking USDJPY up to 94 and possibly even 95.

Scenario #2: Increased Asset Purchases > Potential for Disappointment

While we would like to think the best of the BoJ, the second and most likely scenario is a contained expansion in monetary policy that would allow the Bank to re-evaluate the market's reaction and increase stimulus further at the end of the month.

Currently, the BoJ is buying JGBs up to three years, and if they extend purchases to five years and leave it at that, it would probably be interpreted as a disappointment. If they expand purchases to ten years, it would be neutral to slightly bearish for USDJPY, but if they expand the maturity of bonds purchased to 30 years, it could lift USDJPY, although the gains would be nominal.

Aside from the size and scope of asset purchases, the BoJ is also widely expected to form a new asset-purchase fund by merging current JGB purchases with Rinban operations. They are also expected to abolish the banknote rule, which limits long-term JGB purchases to the amount of banknotes in circulation.

Scenario #3 - No Major Changes to Asset Purchases > Bearish for USD/JPY

The third and most disastrous scenario for USDJPY would be no major changes to the BoJ's asset-purchase program. This is the least likely scenario because to forego any major action would be a sign of weakness for the new BoJ governor and raise the question of whether the Bank will be able to make do on their promises at all.

Under this scenario, they would still probably abolish the banknote rule and merge JGB and Rinban purchases, but that won't be near enough to pacify the lofty expectations the Japanese government itself has set.

According to the CFTC's IMM report, many speculators are short yen already, so in order for the rally in USDJPY to regain momentum, the BoJ will need to over-deliver. Therefore, anything short of open-ended QE and a major expansion in the scope and duration of asset purchases may not be enough. Nonetheless, expect some big moves in USDJPY on the heels of Wednesday night’s Bank of Japan meeting.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.