With the global coordination of the central banks of the world providing unlimited easing, it seems like there are no bounds to how high stocks can go or how low the Japanese yen (NYSEARCA:FXY) falls. However, one key resistance have formed to keep future risk rallies in check: the dollar/yen rate of 100. Yen support has held past the S&P 500's (NYSEARCA:SPY) 1600 breakout and has topped for nearly a month. Without yen confirmation, any further increases to this rally are suspect at best.
Why does this dollar/yen rate matters so much to the direction of risk assets? The key is the yen carry trade. With the recent shift in policy in Japan to Abenomics, the Bank of Japan now has the most aggressive monetary policy in the developed world. Thus the yen is the cheapest currency to borrow. Banks and large financial institutions borrow yen to either lend it in a higher yielding currency such as the Australian dollar or use cheap borrowing to finance purchases of risk assets such as stocks and commodities. The "carry trade" works as long as the yen depreciates or maintains it current value. Appreciation in the borrowed currency makes the real cost of the borrow too high to profit and causes this trade to unwind. As with the sharp rise of the US dollar and yen during the 2008 financial crisis showed, a reversal of a carry trade can cause massive short-term currency appreciation and sell-offs as risk and borrowed currency is needed to pay off carry trade related debt.
Abenomics has caused the yen to replace the dollar as the primary carry currency, and any rally in risk is predicated on the ability of the yen to continue to fall, so that borrowing continues to grow cheaper. 100 is a key level on the yen because it reflects the break-even purchasing power parity between the yen and the US dollar. Although the economic fundamentals of Japan and the yen are horrible, if this support holds, expect the carry trade to unwind and cause a sharp move to the upside for Yen. I expect a retrace can reach as far as USD/JPY reaching 90 before continuing its decline. However, a break-out above 100 is a sign of the lost of trust in the currency and will likely lead to the collapse of the yen to 200 and beyond.
As a result, the way to trade this is to go long yen and point above 99 and with a stop 100.10. However, with that stop, sell double the amount of yen to reverse the position and place a new stop at 99.01. Based on COT data, shorting the yen is one of the most stretched trades within all the capital markets and any reversal will trigger enough short covering for a significant rally. My short-term price target for the dollar/yen is 93, and plan on reapplying shorts once buying eases beyond that point.
Disclosure: I am long FXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long the Japanese Yen on the spot market.