Don't Dismiss USD/JPY Lower as Memories of 2003 'VaR Shock' Arise
- JGB yields have been on a steady path higher the past month.
- In 2003, when JGB 10Y yields quadrupled, JPY TWI rallied +8% over the same six month period.
- As market volatility is set to rise with summer ending, it's a good time to review risk management principles.
After what was a relatively quiet summer, at least by 2016's standards, market participants should be eager for autumn as it portends the return of liquidity, and thus, volatility. While it may take a bit of time over the next week or so to see conditions normalize, with the European Central Bank meeting this Thursday and the Federal Reserve meeting on September 20-21, there are big hurdles for markets to clear that will undoubtedly attract traders' attention.
Perhaps, however, the number one thing traders should be watching as they return from holiday is what's going on with the Japanese Yen and JGBs.
If you've noticed, Shinzo Abe and Haruhiko Kuroda, the Japanese Prime Minister and Bank of Japan Governor, respectively, have been out in the news recently. Both have taken to defending 'Abenomics,' with strong promises to deliver more easing over the coming weeks and months. Surely, this policy signaling is expected to weaken the Yen - so then why do we find ourselves looking in the other direction?
It's known as a 'VaR shock,' and it's what happened in 2003 in the JGB market. A rapid rise in yields as traders liquidated their long JGB positions forced up the Japanese Yen by an impressive amount in a short time: as the JGB 10-year yield quadrupled from 0.4% to 1.6% over six months, the Japanese Yen trade-weighted index rallied by ~+8%. In a VaR shock, liquidity is an issue; traders are not able to sell their securities at their desired prices; the phenomena becomes self-fulfilling.
Given levels of BOJ ownership coming into this year - and thus diminishing liquidity in JGBs - we raised the alarm on a potential BOJ-induced VaR shock in December 2015. Likewise, it's been on our radar consistently since then: in January 2016; in March 2016; in April 2016; and most recently, on August 2, 2016. It's time to talk about it again.
Quietly, over the past month since we last wrote about JGBs, VaR shock-like conditions have started to materialize. In August 2016, JGBs posted their worst month performance - the fastest rise in yields - since 2010. From its low at the end of July through the time of writing today, the 10-year JGB yield jumped from -0.30% to -0.02%.
Is liquidity becoming a problem in JGBs? It's possible. At the end of 2015, the JGB owned just north of 30% of all outstanding JGBs; at the end of July 2016, the JGB owned a tick higher than 38% of all outstanding JGBs. Their pace for absorbing the JGB market has accelerated over the past few months: coming into 2016, the BOJ was on pace to own at least 50% of all outstanding JGBs by June 2018; now they will do so by the end of 2017.
As you might conclude by now, if JGB yields continue to spike, and the BOJ proves ineffective at quelling market concern at their emerging policy impotence, the odds are high that the Japanese Yen will turn around its recent weakness and pivot back to strength. Now, after Friday's lackluster August US Nonfarm Payrolls report, USD/JPY may be susceptible to greater downside than previous envisioned. Twenty-year seasonality trends likewise support weakness in the pair.
--- Written by Christopher Vecchio, Currency Strategist
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