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Along with the long bond position, one of the great one-way trades since the start of the Global Financial Crisis was to be long of Japanese yen in the foreign exchange markets. So while equities fell from October 2007 highs to March 2009 lows and then bounced over 200%, USD/JPY just fell one way from its high of 124.14 in July 2007 (3 months before the S&P peaked) to 75.57 in late 2011, with barely a bounce along the way.

Foreign exchange is of course predominantly an interest rate play, and as the interest rates and currencies move out of line, arbitrage opportunities arise. Of course, the currency does move to extremes from the interest rate equilibrium; quantitative easing and euro sovereign debt issues being the most recent reasons. But the current sudden bout of JPY weakness is more to do with incorrect market positioning than any economic fundamentals.

On 14th November Shinzo Abe (Japan's opposition leader, former Prime minister and likely next leader at the upcoming election) called on the central bank to print "unlimited yen" to reach a 3% inflation target, and "step up public spending", even in the face of public debt close to 230% of GDP. This is of course just typical bold hot air that politicians rant close to elections. The independent BOJ would never implement such "unlimited" Quantative Easing and in fact money supply has grown every year in Japan since the end of the bubble. Deflation is not their issue, it is demographics and the massive accumulation of public debt.

What his comments have done though is rout the foreign exchange markets. Positions were long yen and suddenly fear a future leader intent on destroying the currency. Markets always overreact!

The extent of the overreaction though can be seen by the currency pairs overlaid against the respective 2 year interest rate differentials. The first chart shows USD/JPY having broken from the interest rate correlation in June 2012 and the move was further exacerbated by Abe's recent comments. The 2 respective yields indicate the currency should be trading nearer 76.70 than the current 82.23.

USD/JPY vs 2 year interest rate differentials
(Click to enlarge)

Shorting the USD/JPY at current levels looks compelling on the weekly charts, last week we saw DeMark buying exhaustion (Green 9) as well as a close above the 2 standard deviation Bollinger Band. Statistically, the price only stays above here 2.5% of the time in the long term. This week's current reversal appears a good opportunity to short the currency with a tight stop loss at 82.75, above last weeks high. However, with the ongoing fiscal cliff talks, the USD will be prone to volatility so are there better opportunities to buy the JPY?

The Australian dollar (AUD) has looked overbought for many months not only against all other G10 currencies but also many other correlations, (e.g. commodity base index, interest rate differentials, etc.) as central banks have become increasing buyers.

AUD/JPY vs 2 year interest rate differentials (source:Bloomberg)
(Click to enlarge)

But the RBA is still in a cutting cycle with a 60% chance of another 25 basis point cut at the next meeting (Credit Suisse STIRT desk Singapore), yet the previous 175 basis points of cuts made since mid 2011 have not seen a corresponding move lower in the AUD/JPY cross. Technically, the weekly charts are showing the cross broke above the Bollinger Bands last week and next week we see DeMark buying exhaustion. HOWEVER 1 warning here. The price is also currently trying to break out above a 5 year resistance line (chart below). A safer short trade would be entering the trade ONLY IF the price breaks back below last week's low of 85.24, with a stop loss level ten at 86.55. Near term target is 76.00, but if there's any risk off deleveraging the rate differentials actually imply 61.00, yes!

AUD/JPY weekly chart for 5 years (source:Bloomberg)
(Click to enlarge)

Probably my favourite choice trade, though, would be to short NZD/JPY. On 8th November New Zealand had some shocking employment data, while the unemployment rate was expected to fall to 6.7% (from 6.8%), it actually rose sharply to 7.3%. The currency closed the day at 64.76 but now trade 67.85, while the 2 year interest rate differentials indicate a level of 63.25.

NZD/JPY vs 2 year interest rate differentials (source:Bloomberg)
(Click to enlarge)

Again we are possibly a week away from complete buying exhaustion (per DeMark analysis) and the price is very close to its 2 standard deviation extreme. So selling when the price breaks below last week's close of 66.99 with a stop loss above the 4 year range trading high 69.74, targeting 63.50 offers great risk reward.

Shinzo Abe's outspoken November comments have left huge opportunities to buy the Japanese yen as he caught the market off guard. The risk reward opportunities are there.

Source: Japanese Yen Is Massively Oversold But Which Currency Pair Offers The Best Value?