Japanese Yen And Gold Are About To Break Out As The Yield Curve Flattens

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Summary

The weakening U.S. and global economies and the BOJ's negative interest rate policy put buying pressures on the yen and gold as safe-havens.

The yen continues to rise as the market is unconvinced the BOJ’s latest monetary policy of yield curve control will work.

A yen intervention by the BOJ won’t succeed however, as traders buy yen when the yield spread between the 10- and 2-year U.S. Treasury Notes is narrowing.

The yen and gold price could be finally heading for a breakout after the Fed left the federal funds rate as is.

Concerns about the weakening U.S. and global economies and the Bank of Japan's, or BOJ's, negative interest rate policy, have put buying pressures on the Japanese yen and gold as safe-havens. Both the JPY/USD exchange rate and gold price, which show a positive correlation (+0.86) over a 100-day period, have been on the rise since the Federal Reserve raised the target range for the federal funds rate by 25 basis points on December 16 to a range of 0.25% to 0.5%. The Guggenheim CurrencyShares Japanese Yen Trust ETF (NYSEARCA:FXY) is up 19.34% year-to-date, while the SPDR Gold Shares (NYSEARCA:GLD), which tracks the performance of the price of gold bullion, is up 24.73% so far this year.

JPY/USD Gold Techncial Chart Click to enlarge

Hawkish comments from some Federal Reserve officials and market expectations for the federal funds target range of 0.75% and 1.0% by the end of this year, have kept the yen and gold price under the 0.01 dollar per yen and $1,377.50 per ounce resistance levels, respectively. Now that the Fed decided at the Federal Open Market Committee, or FOMC, meeting on September 21 to maintain the target range for the federal funds rate as is, the yen and gold price could be finally heading for a breakout.

USD/JPY Technical Chart Click to enlarge

From our viewpoint, the USD/JPY exchange rate could break down the 100 yen level, as concerns rise about the BOJ monetary policy, the U.S. and global economies. The next USD/JPY resistance level is at 94.74 yen, or 61.8% Fibonacci retracement, where the BOJ and the Japanese government may decide to intervene. Gold could break out the $1,337.50 per ounce level, as the yen continues strengthening. The central banks have been boosting their gold reserves as a safe haven in an environment of uncertainty and low or negative interest rates, which may give support for gold to move to the next resistance level, at $1430.00 per ounce.

Gold Techncial Chart Click to enlarge

Yen Continues to Rise as Market Unconvinced the BOJ's Latest Monetary Policy of Yield Curve Control Will Work

Last Wednesday, the Bank of Japan announced a monetary policy reboot, to get Japan out of its risk-aversion mode and to jump-start Japan's sluggish economy, by shifting from targeting the volume of asset purchases to the yield curve, as a flat yield curve hurts bank profits and household sentiment. According to Bloomberg, the short-term target along the yield curve will be the negative 0.1% interest on excess reserves, or IOER, rate, that the BOJ placed on commercial bank reserves in excess of a reserve requirement set by a central bank. The long-term target rate is set at around 0% for the 10-year Japanese government bonds, or JGBs.

The BOJ also pledged to keep easing until inflation overshoots its 2% inflation target, while leaving the scale of asset purchases unchanged at an annual pace of 80 trillion yen, or about $792 billion.

Governor Haruhiko Kuroda said on Monday, in his first speech since the BOJ's decision last week, that the pace at which the BOJ buys bonds will depend on what is needed to achieve its yield curve target but no big increases or decreases were expected for now, according to Reuters. Since the new policy was announced, the USD/JPY exchange rate has been threatening to breach the 100 yen level, as traders may not be convinced that the BOJ tools will achieve the goal.

Former Japanese finance ministry official Eisuke Sakakibara, also known as Mr. Yen, told Bloomberg that the yen could break 100 at any time and may "immediately" strengthen as far as 90. In August, Mr. Sakakibara saw the intervention zone lying between 90-95, when dollar weakness should worry the U.S. Treasury Department enough to agree to yen selling by the Finance Ministry, according to Bloomberg. His assessment seems to contradict the U.S. Treasury Department, as it issued a stern warning in May against any action by the Japanese government to weaken its currency because there should be no disorderly trading in the yen that would justify intervention.

The BOJ may now be tensely watching both the bond and currency markets and be preparing to take appropriate actions if the yen continues strengthening against the dollar and other major currencies. In May, when the Japanese government was about to enter into an all-out global currency war, Finance Minister Taro Aso threatened to intervene in foreign exchange markets and said that the Japanese government would not tolerate a persistent "one-sided" rise in the yen. He warned that the government was "determined to stop it", according to the Australian Financial Review.

USD/JPY 10Y-2Y Yield Spread Techncial Chart Click to enlarge

A yen intervention by the BOJ won't work when the USD/JPY, EUR/JPY, as well as the GBP/JPY exchange rates and the yield spread between the 10-year and 2-year U.S. Treasury Notes are directly correlated, as currency traders will sell the U.S. dollar, euro and the British pound to buy yen when the U.S. Treasury yield spread is narrowing. The three major currency pairs and the yield spread between the 10-year and 2-year U.S. Treasury Notes show positive correlations between +0.70 and +0.78 over a 100-day period, meaning the currency pairs and the yield spread move in tandem, where +1.0 is a perfect positive correlation and zero is no correlation.

The last intervention by the BOJ was in August 2011 when the bank sold a record 4.5 trillion yen and bought U.S. dollars, causing the yen to tumble temporarily. But a week later, the currency was back above its levels before the intervention. At that time, the U.S. was in the middle of a debt-ceiling crisis, with a third-quarter 2011 GDP of 2.0% and unemployment rate of over 9%. The Fed funds rate was between 0% and 0.25%.

Weakening U.S. Economy and Narrowing Yield Spread

It wasn't much of a surprise last week when the U.S. Federal Reserve decided to keep its benchmark interest rate unchanged and pretty much told everybody, "See you in December for a rate decision, maybe" as the U.S. economy is showing signs of a significant slowdown.

The Federal Reserve Bank of New York knocked 50 basis points off its third-quarter and fourth-quarter 2016 GDP forecast on Friday, to 2.3% and 1.2%, respectively, from the previous 2.8% and 1.7%, citing U.S. data in the past two weeks, from manufacturing, retail sales, housing and construction, that has been negative. Taking the latest New York Fed forecast into account, the pace of U.S. GDP annual growth will be just 1.4% year-on-year, the slowest growth since 2009. The current blue chip consensus U.S. GDP 2016 forecast is 1.8%, according to the Wall Street Journal.

US GDP Click to enlarge

Last Tuesday, the Federal Reserve Bank of Atlanta revised its third-quarter 2016 GDP forecast 10 basis points downward, to 2.9% from the previous 3.0%, after the U.S. Department of Commerce said that housing starts fell 5.8% last month from July, to an annual rate of 1.142 million. In fact, housing starts have been volatile, with a deviation of as much as 20% on a month-on-month basis.

London-based IHS Markit said on Friday that its flash U.S. manufacturing purchasing managers index fell to 51.4 in September from 52, marking the lowest level since June, citing weak new orders, especially from exports clients. Any reading above 50 indicates improving conditions. U.S. manufacturing PMI has been on downhill slide since the index reached an all time high of 57.90 in August of 2014.

US Total Nonfarn Payrolls Click to enlarge

Growth of U.S. total seasonally adjusted nonfarm payrolls has declined steadily since the second-quarter 2015, while hourly wages inched up 3.29% from $24.91 per hour in April 2015 to $25.73 per hour in August 2016, or about 2.47% on an annualized basis, despite a rise in minimum wages in some states and cities. Personal consumption expenditures, excluding food and energy, or core PCE, climbed from 109.25 in April 2015 to 111.37 in July 2016, an increase of about 1.55% on an annualized basis. In fact, core PCE has been running below the Federal Reserve's inflation target of 2% since second-quarter 2012.

The yield spread between the 10-year and 2-year U.S. Treasury Notes, one of the economic indicators, has been on the decline since it peaked in December 2014 at 2.66 percentage points, two months after the FOMC decided to end the quantitative easing program. Soon after, Wall Street economists stepped up their speculations about the timing of the Fed's first rate hike and sent fear to bond market, which had already driven the 10-year and 2-year U.S. Treasury Notes yield spread lower.

US 10Y Treasury Yield Technical Chart Click to enlarge

From a historical perspective of the Fed leading up to the last U.S. recession, from December 2007 through March 2009, the Fed began hiking the short-term rate from 1.0% to 1.25% in June 2004 as the yield spread between the 10-year and 2-year U.S. Treasury Notes stood at 1.9 percentage points. By the time the Fed raised the key rate by a quarter-percentage point to 5.25% for the last time in June 2006, the yield spread was already in negative territory.

Conclusions

Concerns about the weakening U.S. and global economies and the BOJ's negative interest rate policy have put buying pressures on the Japanese yen and gold as safe-havens. Both the JPY/USD exchange rate and gold price, which show a positive correlation, have been on the rise since the Federal Reserve raised the target range for the federal funds rate by 25 basis points last December.

The yen has continued to strengthen as the market is unconvinced the BOJ's latest monetary policy reboot will work. To get Japan out of its risk-aversion mode and to jump-start Japan's sluggish economy, the BOJ is shifting its target to the yield curve. But if the yen continues to advance against the dollar and other major currencies, the BOJ may have to be prepared to take appropriate actions.

A yen intervention by the BOJ won't succeed however, when the USD/JPY, EUR/JPY and GBP/JPY exchange rates and the yield spread between the 10-year and 2-year U.S. Treasury Notes are directly correlated, as traders sell the dollar, euro and pound to buy yen when the U.S. Treasury yield spread is narrowing. The yield spread between the 10-year and 2-year U.S. Treasury Notes, one of the economic indicators, has been on the decline since it peaked in December 2014.

Hawkish comments from some Federal Reserve officials and market expectations for a Fed rate hike by the end of the year have kept the yen and gold price under resistance levels, but now that the Fed decided on September 21 to maintain the target range for the federal funds rate as is, the yen and gold price could be finally heading for a breakout.

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