The holiday shortened last week of May, 2015 started with a major breakdown of the Japanese yen (NYSE:FXY) versus the U.S. dollar.
After five months of rangebound trading, CurrencyShares Japanese Yen Trust finally broke down to new lows
if past patterns repeat, the current breakdown is just the beginning of a burst of extended weakness for the yen versus the U.S. dollar
Source for charts: FreeStockCharts.com
The yen is now trading at its lowest level against the U.S. dollar in 12 years. This move suggests that "something" major is underway. After all, even as the U.S. dollar index was still making significant gains against other major currencies into the March 12-year peak for the index, the yen held its ground. It was starting to look as if the U.S. dollar and the yen had become linked. Even speculators seemed to sense that an era of yen weakness was coming to an end: they have spent most of 2015 in gradual retreat from what was a massive net short position relative to previous years. Only a large surge in net short positions in the final week of May seemed to reveal a sudden change of heart.
The latest bout of weakness in the Japanese yen has occurred just as speculator were finally giving up on net short positions
Combining the past persistence of breakdowns for the yen and the potential return of yen shorts, I am inclined to stick with the momentum against the Japanese yen. The basic trade here is to play the breakdown (breakout on USD/JPY) and take profits at some target level or point in time. The shortest period of fresh weakness for the yen was the November to December, 2013 period. Positions would stop out upon an end to the breakdown. As described below, a consensus seems to crowd around 125 as a reasonable target for USD/JPY. I would aim to take profits or stop (aggressively) shorting the yen as USD/JPY approached 130 assuming momentum will help take the currency pair past the median target of 125. Translated to FXY, this strategy represents a target around 74.
Interestingly, I have not been able to ascertain satisfactorily what has materially changed to generate the break from the months-long trading pattern. I do not think it is enough to point out that the U.S. dollar (NYSEARCA:UUP) has regained its former momentum because that former momentum did not include yen weakness from December, 2014 through early May.
A May 27th article from Bloomberg titled "Yen Splits Top Forecasters as Japanese Officials Express Unease" is characteristic of the lack of good explanations. Bloomberg's collection of currency strategists have left the median forecast for USD/JPY at 125 since February (USD/JPY closed the week at 124.2), so it is very possible this breakout is a much delayed shift toward target. Yet, of all the strategists quoted in the article, not a single one provided a yen-specific explanation for his/her forecasts. I had to refer to a Reuters article to get more detail on commentary from Japanese officials. The article described the commentary as "mild but harmonized verbal warnings against excess currency turbulence, cautioning markets against pushing the yen down too rapidly":
- Finance Minister Taro Aso: "'In general, excessive exchange-rate volatility is undesirable.'"
- Chief Cabinet Secretary Yoshihide Suga: "'As agreed by the Group of 20 nations, excessive exchange-rate volatility is undesirable. But I don't think recent moves have reached a point that are considered excessive.'"
- Bank of Japan Deputy Governor Kikuo Iwata: "…repeated the central bank's standard line that exchange rates ought to move in a way that reflects economic fundamentals."
In other words, Japanese officials completely avoided talking about the specific level of the exchange rate. Volatility is not the same as the exchange rate itself.
Finally, in search of a yen-specific catalyst, I sifted through the minutes of the last meeting of the Bank of Japan (BoJ). The minutes were released on May 26th. The meeting was held on April 30th, well ahead of the renewed weakness against the U.S. dollar. The BoJ was relatively upbeat about the economy. In summary:
"With regard to economic activity, members shared the assessment that, in a situation where a virtuous cycle from income to spending continued to operate in both the household and corporate sectors, the economy continued its moderate recovery trend.
Members agreed that Japan's exports had been picking up. They shared the view that it was appropriate to judge exports as remaining on an improving trend, as on average they had increased for three consecutive quarters despite large monthly fluctuations since the start of 2015 due to the effects of the Lunar New Year holidays. Members concurred that exports were likely to increase moderately, mainly against the background of the recovery in overseas economies…
Members shared the recognition that business fixed investment had been on a moderate increasing trend as corporate profits had improved. They agreed that it was likely to continue to do so as corporate profits followed their improving trend…
As for the employment and income situation, members shared the recognition that, with labor market conditions continuing to improve steadily, employee income had risen moderately and was likely to continue to do so…
Members shared the recognition that industrial production had been picking up, due in part to the moderate increase in demand both at home and abroad as well as to the progress in inventory adjustments. They agreed that it was likely to increase moderately."
Of significant note, the BoJ is convinced that Japan will continue to grow above potential through at least 2016:
"With regard to the baseline scenario of the outlook for Japan's economic activity, members concurred that, as domestic demand was likely to be firm and exports would probably increase moderately, a virtuous cycle from income to spending was likely to be maintained in both the household and corporate sectors. On this basis, they shared the recognition that Japan's economy was likely to continue growing at a pace above its potential from fiscal 2015 through fiscal 2016."
The BoJ expects growth thereafter to moderate.
Most importantly, the outlooks on inflation across the members of the BoJ are mixed, but they are clearly biased toward hitting the 2% target sometime in 2016. CPI forecasts were revised downward and risks to inflation are skewed to the downside. From the minutes:
"In terms of the outlook for prices, many members shared the view that (1) as the underlying trend in inflation steadily rose and the effects of the decline in crude oil prices dissipated, the year-on-year rate of increase in the CPI was likely to accelerate toward 2 percent - the price stability target; (2) although the timing of reaching around 2 percent depended on developments in crude oil prices, it was likely to be around the first half of fiscal 2016…; and (3) thereafter, the year-on-year rate of increase in the CPI was likely to be around 2 percent on average."
"A few other members" did not expect to see 2% inflation within the forecast period ending fiscal 2017. Yet, all members seemed to agree that the output gap would continue to improve into 2017 with excess demand increasing.
Given the economic numbers and the commentary, I normally would be amenable to agreeing with Ian Stannard of Morgan Stanley that the Japanese yen is the most under-valued currency among the G10 by a "considerable amount.". However, the Bank of Japan remains very committed with full steam ahead on its program of QQE (quantitative and qualitative easing). One member expressed concerns that QQE had already reached the limits of its useful given the improvements in the outlooks for inflation and the economy. The various responses to this member's objections made it clear that he was soundly over-ruled. From the voting records, I am guessing the dissenter was Mr. T. Kiuchi.
This strong commitment to continuing QQE is reason enough for continued weakness in the yen. Perhaps traders just needed confirmation from the minutes that the improving economic numbers from Japan were not reason enough to keep the yen steady with the U.S. dollar.
Going forward, traders should watch carefully for jawboning from Japan and even from the U.S. as fears rise again about "unfair" advantage from currency manipulations. When USD/JPY first zipped toward 120 in late 2014, this kind of noise was apparently enough to hold the currency pair around that level for months. The next line in the sand could very well be in the 125 to 130 range.
Be careful out there!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In forex, I plan to execute the trading strategy as stated in this piece.