The combination of the Federal Reserve and the Bank of Japan both deciding to keep rates on hold gives us reason to believe that the yen can keep climbing higher. The Fed's decision was widely regarded as a given, but many felt the Bank of Japan would have to act in order to curb the rocketing yen. With neither acting and a successful Brexit vote looking like it could actually happen, the yen (NYSEARCA:FXY) is looking like a great long right now to us.
When you look around the world there are a number of central banks which look completely bewildered at the moment. But none more so than the Bank of Japan. Here's an economy with negative interest rates and a currency that's quite frankly out of control and potentially sending the proud nation deeper into deflation.
It would be unfair not to point out that as bewildered as the Bank of Japan appear, the rest of the world is just as confused by the strength of the yen. Ordinarily the yen is strong because stocks (NYSEARCA:SPY) (NYSEARCA:IWM), junk bonds (NYSEARCA:HYG) and emerging markets (NYSEARCA:EEM) are all in free fall. But while the markets may not be having the best week, only recently the S&P 500 was closing in on an all-time high. One argument has been that the smart money has been anticipating a huge market crash coming and has flown to safety.
But is there one coming? The Brexit vote definitely has the potential to cause trouble in financial markets, but an all-out crash is an outside bet in our eyes. According to FIS, it expects the S&P 500 to decline by 5% in the weeks after a successful Brexit vote, should there be one. Elsewhere, it expects British markets (NYSEARCA:EWU) could drop as much as 15%. Which is a lot better than what stress tests conducted by risk modeling company Axioma reveal. Its test show that British equities could be in for a much deeper loss of 24%.
So while there may not be an out and out crash coming in US equities, many experts are predicting reasonable declines across the world. It doesn't take much to spook the markets in our opinion, and we expect to see the yen rally even higher if Britain exits the European Union.
Source: DailyFX USD/JPY
At this point in time we would not be surprised to see the USD drop below that symbolic ¥100 point in the next couple of weeks and then go as low as ¥95. It really does depend on how severe the fall out from a successful Brexit vote is.
We agree with FIS and believe the worst case scenario for US financial markets has the Brexit causing them to drop by 5%, which we expect could send the USD to ¥95. Which although it sounds strong, it was not that long ago that the currency pair were trading at this level. In fact, as the chart above shows, it was only three and a half years ago when the US dollar was buying ¥80.
Of course if Britain were to vote to remain a part of the EU then all this panic will have been for nothing. There is a reasonable chance that the JPY would weaken against the USD as a result of a remain vote succeeding also, so it is worth bearing this in mind. But we are siding with the leave vote winning. According to The Financial Times, the leave vote is ahead with one week to go.
In our opinion, the yen is a great place to be right now for investors who are concerned about the effects the Brexit will have on financial markets. As with gold, the more fear that creeps into the market, the more funds we expect to head into it. We see limited downside risk for the currency until at least the end of July when the BOJ next meets. Even then, the BOJ does look unwilling to take further action, instead we believe they are waiting for the Fed to make the first move in the hope that it solves all their problems. Most economists are ruling out an increase in rates by the Fed in July, with September the favorite, giving the yen up to three months to strengthen further.
For now we are targeting ¥95 for the USD/JPY pair, equating to a drop of 8.5% from the current price of ¥103.9.
Disclosure: I am/we are 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.