Carry trades are up sharply today which makes it quite timely for us to release our fourth quarter Fundamental and Technical outlook for USDJPY. The Bank of Japan left interest rates unchanged but the US dollar is battling with the prospect of lower interest rates. Although the Yen could weaken further against the high yielding currencies like the Australian and New Zealand dollars, both technicals and fundamentals suggest that we are nearing a top and reversal of significant proportion.
Risk aversion wrecked havoc on long USDJPY positions in the third quarter of 2007 as the credit crunch and the stock market swoon in late July and early August created massive liquidation in the carry trade. GBPJPY lost more than 3000 points in just one month, EURJPY lost nearly 2000 points and USDJPY dropped from a high of 124.13 to a low of 111.97 before finally finding some support. While some of the high yielders were able to recapture parts of their declines (with EURJPY recovering nearly all of its July-August losses) there is no doubt that appetite for risk which was so prevalent during the first half of the year and which stoked the demand for the carry trade pushing the yen to multi-year lows, has now been significantly curbed. This change of sentiment was especially evident in USDJPY which has seen the weakest rebound amongst all the carry trades. The pair has been hampered by the contracting interest rate differential between the dollar and the yen which has made the carry trade far less attractive. As the end of the year approaches USDJPY is likely to be capped on the upside as US interest rates are expected to be reduced further, while Japanese rates stand a good chance of rising if the latest economic developments in the island nation continue their positive trend. While the bulk of yen strength in Q4 is still likely to come from any additional bouts of risk aversion in the financial markets, recent economic data from Japan offers yen longs some hope that BOJ will soon begin the interest rate normalization process in earnest, reducing yen’s attractiveness as a funding currency and allowing it to trade more on its own economic fundamentals rather than just pure carry trade dynamics.
USDJPY and the Dow - No Longer a Perfect Pair
An interesting development occurred in the markets as Q3 of 2007 was about to end. USDJPY, which up to that time had been highly correlated with the movements in US equity indices started to materially diverge from them. Nowhere was this more apparent than in the Dow Jones industrial Average which not only recovered its August losses but went on to set new record highs above the 14,000 level. Meanwhile USDJPY traded well below its 2007 high of 124.23 settling into 114.00 - 117.00 range as the quarter ended. What’s been the difference between Q2 and Q3? US interest rates. On September 18th the Federal Reserve Bank of New York surprised the capital markets by lowering rates by full 50 basis points rather than 25bp forecast by most analysts. This action instantly reduced interest rate differentials in the pair to 375bp from 425bp just a day earlier. More importantly the Fed’s action signaled to the market that the US Central bank was now following a loosening monetary policy path and most likely would lower rates further before the year end. With currency market now anticipating additional contraction in the interest rate spread between dollars and yen, USDJPY started to lose its luster as a carry trade. This explains why despite the return of risk appetite as evidenced by new highs in DJIA, USDJPY has not followed suit.
Japanese Economy Perking Up
While the US economy continues to suffer from the sub-prime fallout, the Japanese economy is beginning to show signs of resurgence. After a horrid second quarter which saw GDP actually shrink by -0.3%, the Japanese economy appears to be on the rebound as consumer sentiment has bounced off the lows set in Q2. As Japan’s export centric corporate sector which has benefited mightily from lower exchange rates, continues to generate profits, the Japanese worker is finally starting to see those profits trickle into wage gains. In August Labor cash earnings turned positive after 8 consecutive months of contraction. If this trend can sustain itself, it will put an end once and for all to the deflationary forces that have depressed the Japanese economy for well over a decade. As wages once again begin to grow, consumer sentiment and along with it consumer spending should improve driving overall economic growth higher. Already early signs of a pick up can be seen in the latest Small Business Confidence survey which surprised to the upside printing at 49.1 - within a whisker of the 50 level that signifies expansion. While it is too early to gauge the ultimate strength of the Japanese economy, if the latest data continues to show an improvement in wage gains and consumer spending the BOJ will become far less reluctant to normalize its interest rate policy which could prove very constructive for the Japanese currency as we enter 2008.
BOJ - Hike Before Year End?
Throughout 2007 the BOJ has been very slow in tightening monetary policy, preferring a highly gradualist approach that saw the central bank raise rates only twice to 50bp since abandoning the Zero Interest Rate Policy in July of 2006. The reason behind the BOJ’s cautious stance has been the fear by monetary authorities that a too rapid rise in short term rates would stifle the budding recovery of the Japanese economy, possibly sending the country back into deflation. Nevertheless, the policymakers are acutely aware of the negative impact of unnaturally low interest rates as the country’s currency experienced multi-decade lows against many of its G-10 counterparts in Q3 of 2007. Given a chance, the BOJ would like to begin the normalization process in earnest, steadily raising rates throughout 2008. As we stated earlier, wage growth will be the key to allowing Mr. Fukui and company to pursue a more aggressive monetary policy. However, the capital markets may be already anticipating this course of events. Note in the following chart the 3 month LIBOR rate remains well above the BOJ target rate of 0.50%. In the past LIBOR rates have been a good predictor of BOJ target rates by several months. If the traders at the short end of the Japanese yield curve are correct, the BOJ may hike rates before the year end. While an additional 25bp rate hike would not have a significant impact on the absolute interest rate differentials between the yen and the high yielders, it may be a signal that this time the tightening policy will be much more sustained than in the past.
Japanese Retail Refuses to Give Up
No market participant has been a greater seller of yen than the Japanese retail trader. Faced with a paltry 0.5% yield on their savings, the aging population of Japan has redirected its vast pool of savings towards much higher yielding currencies such as the British pound, the Australian dollar and the New Zealand dollar. Indeed, Japanese retail has been one of the dominant forces behind the rise of the carry trade in 2007. Bloodied but unbowed by the events of July and August, many Japanese investors continue to be sellers of yen on any rise in the currency. Japanese financial institutions raised as much as $7 Billion of fresh capital at the end of September to invest into higher yielding foreign assets. The Japanese retail bid for the carry continues to be one the primary reasons for yen’s weakness. However, even there it may not translate into much higher USDJPY prices as most of the Japanese funs will likely be directed towards the higher yielding commodity currencies such as the Australian and the Canadian dollars where the possibility of yet more rate hikes remains alive making the carry trade against those currencies much more attractive.
EURJPY - How Much Higher?
EURJPY has been the one carry trade pair that recovered nearly all of its losses from July and August. The most recent rise in the EURJPY did not come as a result of expectations for further widening in the interest rate spread in the pair, but rather from the euro’s old familiar role as the anti-dollar. As dollar weakness returned to the market after the Fed’s surprise 50bp rate cut, the primary beneficiary of this trend has been the EURUSD which reached all time highs, taking EURJPY with it for the ride. However, the latest data for the Euro-zone suggests that economic activity in the 13 member region is slowing precipitously as higher exchange rates and lackluster retail demand weigh in growth. Given those conditions, it appears highly unlikely that the ECB will raise rates for the rest of the year (for more information on why ECB will not go beyond 4%, see our Special Report here). If the ECB does indeed stay stationary, the EURJPY trade may lose some momentum as the allure of additional rate hikes will fade. The pair could still continue higher on dollar weakness alone however its rise will be tied solely to anti-dollar sentiment and will therefore become very vulnerable to any future bouts of risk aversion or the possibility of yen strength as Japanese economy continues to improve triggering further rate hikes from the Japanese central bank.
Conclusion
Although USDJPY continues to be buffeted by the winds of the carry trade, as 2007 comes to a close those forces have become decidedly weaker in determining the direction of the pair. The surprise 50bp rate cut by the Federal Reserve Bank of NY reduced the interest rate differential between the two currencies for the first time in three years. Furthermore, additional rate cuts by the Fed before the year end are probable and will likely weigh on the pair in Q4. Little wonder that USDJPY has decoupled from the rise in the DJIA, as increased risk appetite has not translated into better demand for the pair given the compression in interest rate differentials. If Japanese economy continues to show improvement especially in the labor wage data arena, the BOJ will be far more motivated to begin normalizing interest rates sooner, which could boost the yen even further. However, if the Japanese economy flounders and wages remain moribund, the yen will continue to be used as the funding currency in the carry trade especially by Japanese retail traders who continue to seek yield. Therefore, the yen could see more weakness ahead but only against the high yielding commodity currencies such as the Aussie or the loonie. Against the dollar any yen weakness should be contained as further cuts in the Fed funds rate will make the carry trade in the pair less appealing.
Technical Outlook: Nearing a Top and Reversal of Significant Proportion
USDJPY may have completed a 12 year correction in the form of a triangle at 124.13. Triangles unfold in 5 waves (A-B-C-D-E) and the structure below is clearly in 5 waves. There is risk of wave E extending higher towards the next major resistance level of 128.00 but the weight of evidence suggests that wave is complete at 124.13. For one, wave E is close to 61.8% of wave C. Alternating legs of triangles are often related by 61.8% or a derivation of Φ (Phi….618). Wave E would be exactly 61.8% of wave C at 122.57. The top was at 124.13. A difference of just 155 pips when projecting a move that is nearly 3000 pips works out to just over a 5% error. The time relationships between the different legs of the triangles also favor the idea that wave E is complete at 124.13. The weeks that each leg of the triangle took to unfold (from A to E) were 41, 16, 27, 37, 30. The average length of time for each leg is 30.2 weeks. Wave E took 30 weeks. The 'look' is right for a top and reversal of significant proportion. The pair should be on its way towards the base of the triangle at 101.26. 124.13 is critical to the bearish bias.
