USD/JPY: From One Cliff To The Other?

Includes: JYN
by: Evariste Lefeuvre

Earlier today, Japan's lower house passed a $477bn budget deficit financing bill, which will finance 40% of government spending before FY 2014 (March 2013), meaning they will avoid the Japanese version of the "fiscal cliff." They have also stated that they would be willing to cooperate further with the BOJ. The BOJ expanded the size of the Asset Purchase Program on October 30, to 91 trillion JPY in a unanimous vote, providing additional fiscal stimulus to Japan with an uneasy forecast for global trade looming.

The USD/JPY spiked sharply over the past few days, as a result of further easing signals from the BOJ and the Japanese government. Where will the USD/JPY end up?

1. Risk aversion: The USD/JPY is a clear cut indicator of risk-on/risk-off. Historically, VIX and USD/JPY were negatively correlated: higher risk aversion would come along with a lower USD/JPY. This was clearly the case over 2007-2008, with the unwinding of carry trade strategies.

As can be seen below, the correlation is not only unstable but has not been significant since mid-2010. It would therefore be dangerous to base my analysis on the sole convergence between VIX and USD/JPY, (especially since higher VIX does seem to imply higher USD/JPY.

I tried to measure the USD/JPY against my favorite measure of risk aversion (Gold/Oil ratio or VIX slope). I found an unwelcome decoupling between USD/JPY and the GOR. If the recent past is a guide, the USD/JPY has generally trended toward the GOR in periods of disconnect. It would mean a lower, not a higher USD/JPY ahead.

2. FX and Equity-like Risk: As every advanced-country currency, the USD/JPY monthly change partly offsets the over/under performance of relative stock prices. As can be seen below, any over performance of the Nikkei against SP 500 comes along with a stronger USD/JPY. It is true that the equity market relative return spread tends to overreach but the current reading is clearly pointing to a slightly stronger USD/JPY.

3. Yields: In a ZIRP world with unconventional policies on both sides of the Pacific, yields should not play a major role in explaining currency moves. A long-run chart shows that the USD/JPY is well correlated with the UST-JGB 10-year spread (after a long disconnect between 2009 and 2010). However, if we zoom in closer, the 10-year spread suggests a lower USD/JPY at around 78.

The message is the same if we look at the 2-year spread: USD/JPY should stand around 78.

The bottom line is: barring an unconvincing signal sent by the VIX, all indicators suggest that the USD/JPY upward move should be limited and that the pair is likely to return to a lower level soon. Technical analysis, along with relative equity short-term returns suggests that the current trend could gain momentum up to a resistance at 82.6/9. But all other cross asset indicators are bearish on the pair.

Disclosure: I 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.