Far-Reaching Ripples From Japan's Newly Negative Rates

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Includes: FXA, FXY, JYN, YCL, YCS
by: Dr. Duru

Summary

The Bank of Japan introduced a three-tier interest rate regime to ease the country's financial system into the world of negative interest rates.

The move caught traders by surprise who were responding to increasing fear in financial markets with a bull run in the yen unseen since 2012.

The move also further isolates the Fed on island of policy divergence and will put market sentiment to the test in coming days and weeks.

On Wednesday, January 27th, the U.S. Federal Reserve stared down volatile conditions in financial markets and decided to avoid addressing them directly. The Fed chose to offer boiler plate references like the following:

"The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook."

When the Bank of Japan (BoJ) came up to bat almost two days later, the BoJ made very clear its concerns about global economic and financial developments. From "Introduction of 'Quantitative and Qualitative Monetary Easingwith a Negative Interest Rate'":

"Recently, however, global financial markets have been volatile against the backdrop of the further decline in crude oil prices and uncertainty such as over future developments in emerging and commodity-exporting economies, particularly the Chinese economy. For these reasons, there is an increasing risk that an improvement in the business confidence of Japanese firms and conversion of the deflationary mindset might be delayed and that the underlying trend in inflation might be negatively affected."

This concern convinced the BoJ to add interest rates to the monetary policy formerly called Quantitative and Qualitative Monetary Easing (QQE). The vote was a close 5-4 decision that sent interest rates negative in a tiered fashion similar to the method used by the Swiss National Bank:

"…the Bank will adopt a three-tier system in which the outstanding balance of each financial institution's current account at the Bank will be divided into three tiers, to each of which a positive interest rate, a zero interest rate, or a negative interest rate will be applied, respectively…"

The "Basic Balance" earns an interest rate of 0.1% which is unchanged from previous policy. The "Macro Add-on Balance" earns a zero interest rate. The "Policy Rate Balance," which is the excess left over from the Basic and Macro Add-on Balances, earns the negative rate of -0.1%. The Bank will deduct funds from the first two accounts if financial institutions withdraw cash from the Policy Rate Balance in excess of certain limits. The tiered approach is supposed to allow financial institutions the ability to continue to act as intermediaries despite impaired earnings. The Bank further noted that it is prepared to apply these policies, and more if necessary, for as long as it takes to achieve its inflation target of 2%. In "Key Points of Today's Policy Decisions", the BoJ addresses various potential concerns in a FAQ format. One of those concerns is "how far into negative territory can the interest rate be moved?" Perhaps there is a problem in translation from Japanese to English, but the BoJ does not directly answer the question except to point out that other central banks have even more negative rates: Switzerland (minus 0.75 percent), Sweden (minus 1.1 percent), and Denmark (minus 0.65 percent). So, to-date, we can assume Sweden represents the limit until another central bank ventures out even further…which appears to be the global trend until at least one of these central banks finally shifts rates upward.

In other words, the BoJ has added its own confirmation that this is indeed a low-rate world. The ripples from this confirmation are far-reaching and particularly important for traders in financial markets.

The impact on the Japanese yen was immediate but yen-buyers tried to put up a fight. After all, the BoJ cannot wipe away all the panic and fear in the market that drives traders and investors to prefer "safety" in the yen.

And just like that, the breakdown for USD/JPY ends.

At first, buyers hopped onto the weakening yen as a lucky buying opportunity. The 5-minute chart below shows how quickly buyers tried to fade the yen only to have the sellers return with even more zeal (USD/JPY goes up when the yen is weak, down when the yen is strong).

Traders faded the first trigger reaction to the BoJ announcement. The resumption of yen selling should become a defining theme for coming weeks or more.

Source for charts: FreeStockCharts.com

With the BoJ taking action, the U.S. Federal Reserve is even more isolated on the island of policy divergence. It is hard to imagine that the Fed will continue hiking rates when all its peers in major central banks are officially in or have been in full retreat on monetary policy. Combine newly negative rates in Japan with an unimpressive annualized fourth quarter real GDP of 0.7% print for the U.S., and market participants beat a hasty retreat in Fed rate hike expectations. The market just barely expects the next rate hike to come in December. Just two weeks ago, James Bullard of the St. Louis Federal Reserve accomplished what looked like then a large feat of pushing expectations for the next rate hike out to June.

The market now expects the next rate hike to come in 11 months! The marginal 52.8% probability represents a dramatic change from just two days ago post-Fed.

Source: CME Group FedWatch

Currency speculators also found themselves trapped on an island - this one an island of yen bullishness. Going into the BoJ meeting, speculators were ramping up net long positions. Speculators had not even been net long the yen since October, 2012. Net long positions have not been this high since February, 2012. As the intraday trading showed above, speculators are likely next to battle tensions between following the BoJ in weakening the yen versus buying the yen as an on-going refuge from the very forces that motivated the BoJ to ease. While the market struggles to adjust to a new reality, traders will need to move quickly to take advantage of the resulting churn.

The Bank of Japan caught speculators flat-footed: they were in the middle of ramping net longs to levels last seen in late 2012. Since then, not a single week had even featured net long positions.

Source: Oanda's CFTC's Commitments of Traders

This episode hits the "pause button" on the warning I wrote at the beginning of the year in "The Japanese Yen Flashes Red for 2016." I pointed to the yen's gathering momentum and important technical moves:

"Traders of forex and stocks will do very well to pay heed to the message in the Japanese yen. It is flashing red for 2016 and making me inclined to bias bearish until AUD/JPY can at least recover its large losses from the last two trading days."

AUD/JPY, the Australian dollar versus the Japanese yen, needs to retest resistance at its 200-day moving average (DMA), around 88, before it erases those large losses that concerned me. Given that 200DMA resistance held throughout 2015, I will assume another failure to break out of this downtrend will deliver the next bullish signal for the yen and the next bearish signal for financial markets.

AUD/JPY continues a sharp bounce from recent 3-year lows as market sentiment is trending upward.

Source for charts: FreeStockCharts.com

Be careful out there!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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: In forex, I have long and short positions against the Japanese yen (short AUD/JPY).