Shortly after the U.S. markets closed Wednesday, a series of violent moves began across the currency market. The U.S. Dollar fell below the 80 level against the Yen, with the Yen surging 4% in one hour to peak at 76. This peak far surpassed the Yen's previous all-time high of 79 in 1995 that followed the Kobe earthquake. The Dollar also fell to an all-time low against the Swiss Franc at the same moment, with the Dollar forcefully tumbling below the .90 level for the first time ever.
Notably, however, the dollar did not fall significantly against other currencies in this span. It traded flat against the Euro, British Pound, and Canadian Dollar, while the U.S. Dollar rose sharply against the Australian Dollar and the New Zealand Dollar. Comparing the strongest and weakest currencies during the turbulence, the Yen rose 6% against the New Zealand Dollar. Despite the new all-time lows for the Dollar against both the Franc and the Yen Wednesday, the story here is not Dollar weakness.
Rather, the story is further unwinding of the carry trade. Traders are actively avoiding risk in the wake of the tragic events in Japan. Metals, oil, and stock markets are all selling off in tandem. In addition, "risky" currencies are being sold. The obvious targets are the high-yielding Aussie and New Zealand dollars. Hedge funds have been borrowing Yen at low interest for years, depositing them in higher-yielding Aussie or New Zealand Dollar denominated accounts, leveraging the trade up, and collecting the interest rate differential. It's usually an easy trade.
However, when the Yen rises, these leveraged trades all have to be taken down in a hurry. The Yen gets short squeezed, and wild currency gyrations follow. This pattern occured frequently in the 2008 financial crisis, as the Yen repeatedly pressed higher while financial markets tanked. The forced unwinding of the carry trade largely subsided after market volatility subsided in 2009.
However, when market volatility returns, forced carry trade unwinding often rears its head. In addition, the Japanese earthquake changed the equation by removing any motivation to sell Yen, even at higher prices. The Dow Jones reported that:
The USD/JPY's decline to the 76.25 low was mainly due to a lack of JPY-selling investors, says Satoshi Tate, a senior dealer at Mizuho Corporate Bank. "We no longer have active Japanese long-term investors who have been aggressively buying assets overseas"; he adds "this is the main cause of the dollar falling to a surprising level of Y76.25. Improving these investors' risk-taking appetite is a must for the dollar to recover further."
In the past, Japanese investors would see the Yen rising and deploy capital overseas. Now, due to the earthquake, Yen are being hoarded at home. Some ATMs in Japan had quit working Wednesday, and people are fearfully reclaiming their savings from banks. Yen are not leaving the country for the time being. Combine this Yen hoarding with the fact that hedge funds and speculators all had their stops in the same place and all wanted to exit the trade at the same time -- the moment the 1995 record price level in USD/JPY was breached to the downside -- and you get a dramatic result in the USD/JPY that the Wall Street Journal reported as one of the five most violent moves in Dollar/Yen trading history. Click to enlarge:
Also, in the past, the Japanese central bank would have generally intervened to cap the value of the Yen. Wednesday, it chose to step aside and let the markets work. It is unclear whether the bank failed to intervene because it simply couldn't have stopped the move, or whether it intentionally wanted the Yen to strengthen. However, it seems that the Yen can keep going higher in the short run. The Japanese have traditionally resisted a stronger Yen as it weakens their manufacturers' competitiveness on the global markets. But at the moment, a stronger Yen allows the country to buy much-needed imports for rebuilding damaged infrastructure at better prices. A strong Yen may be preferable momentarily.
So what is a currency trader to do? Simply step aside and not trade the Yen or Swiss Franc for the time being. The Yen is subject to unpredictable news-driven supply/demand forces and the always looming threat of intervention. In addition, any stops could instantly be blown away when new information comes in regarding the unfolding potential nuclear accident.
I'd also avoid the Swiss Franc as it is trading as if it is the ultimate flight-to-safety play and people appear to simply be hoarding it now regardless of price. The Franc is trading at an all-time high versus the U.S. Dollar and the British Pound, and is only a cent away from its all-time high against the Euro as well. As a result, the Franc faces the renewed threat of Swiss Central Bank intervention. The Swiss previously said they would step aside and not intervene in the market after previous efforts to stop Franc appreciation failed. However, they probably weren't imagining a .89 USD/CHF rate or a 1.25 rate on EUR/CHF when they stepped out of the inventionary role. It's not hard to see the Swiss stepping back in to try to protect their own exporters at these levels.
Unless you like trading in whipsawing markets with the constant threat of news, it's best to stay out of the Yen and Franc trades for now. In the longer-term view, the USD/JPY is a good buy here. The Yen will struggle in the future as Japan will have to keep interest rates low for an extended time period, its debt crisis continues to deepen, its demographics will continue to hinder economic growth, and it has to pay for rebuilding after the massive earthquake. On a fundamental basis, it is hard to justify the Yen at an all-time high now. From a technical perspective, however, the spike makes perfect sense. If you are looking to enter a short Yen position, wait for news and volatility to die down before entering a positional trade.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Author frequently initiates trades on currency pairs such as USD/JPY and intends to do so within the next 72 hours, though he holds no positions now.
