After weeks of consolidation, we are finally getting some action in the forex market. The rally in the U.S. dollar extended higher this morning, forcing the EUR/USD below 1.30, USD/JPY to a fresh 4 year high of 101.73 and the AUD/USD below parity (1.0) intraday. While the move in USD/JPY is stealing the headlines, there's no question that this is a broad based dollar rally because every major currency has lost value against the greenback. What started as a post jobless claims uptrend turned into the biggest 2 day move for the dollar in over a month and if next week's U.S. retail sales report confirm that job growth has translated into spending, the rally will continue. Investors are finally beginning to realize that the Federal Reserve is the only major central bank considering paring stimulus in a sea of policymakers who have just taken new steps to increase support for their economies. Top that off with better than expected U.S. data and it is no surprise that the dollar has soared. The only surprise was timing.
Being long USD/JPY in the second quarter has been a true test of patience but it has also been one of our favorite trades because the fundamental divergence in monetary policy direction. In early April, the Bank of Japan unleashed the world's most intense burst of stimulus for their economy. They pledged to pump $1.4 trillion over the next 2 years to boost inflation to 2%. Their initial announcement drove USD/JPY to 99.95 but the currency pair failed to break 100 and treaded water for the next few weeks even as the Fed's optimism about the U.S. economy kept discussions of tapering U.S. asset purchases alive.
3 Criteria for Sustainable Gains in USD/JPY - Achieved
Earlier this month, we said there are 3 criteria for USD/JPY to break 100 and sustain a move towards 105:
1) Rise in U.S. yields - DONE
2) New highs in the Nikkei - DONE
3) Japanese purchases of foreign bonds - DONE
According to the Ministry of Finance's weekly portfolio data, released last night, Japanese investors have finally become net buyers of foreign bonds after selling them for 6 weeks straight. As a result, as long as this trend continues, which we believe will, USDJPY will extend even higher. If the BoJ is successful in achieving its 2% inflation target, it would be consistent with a USD/JPY level of 104/104.50. The Bank of Japan has eliminated any reason to buy yen over the next two years and local investors are finally beginning to realize it. The Bank's commitment to bold easing means they will do everything in their power to drive down yields, leading to a more aggressive shift out of Japanese bonds by domestic investors, who will look abroad for higher yields. Moreover, they will do it on an unhedged basis, as the BoJ's policies should keep the Yen weak, eliminating concerns about a currency offset. In other words, the central bank has given Japanese investors a reason to go global and they finally took the bait.
As you can see in the first chart below, trends in USD/JPY can last for a very long time and extend further than most investors would imagine. Between 2007 and 2011, the currency pair dropped nearly 40%, and while there were certainly recoveries along the way, they were brief and shallow. Before that, between 2005 and 2007, USDJPY rose 20%, and a similar move was seen between 2002 and 2005.
Over the past 7 months, USDJPY already appreciated nearly 30%, leading many investors to wonder how much higher can it rise. Considering that the Bank of Japan has just begun easing, we think there's a lot more room to the upside.
The pair's ten-year average is 100, and given the magnitude of the BoJ's actions, at a minimum, we expect USD/JPY to hit 103 with a very likely extension to 105. The moves in USD/JPY frequently overshoot fundamentals and for this reason, we think a first target of 103 and a second target of 105 is reasonable. The 110 level however, may be a stretch. On a technically basis, 103 is significant because it is the 38.2% Fibonacci retracement of the 1999 to 2011 sell-off in USD/JPY and 105 is significant psychologically so many stops and take profit orders are likely to be sitting at that level.
(Click to enlarge)