Added Market Geopolitical Uncertainty Is Sending JPY Higher; More To Come

by: D. H. Taylor

Whereas JPY moving higher previously was driven from economic slowdown, geo-politics are adding a new factor.

The North Korea showdown is adding in a significant risk factor.

Interest rate differential is narrowing significantly.

There is an air of instability and uncertainty in the world. The Trump administration has just bombed Syria. Putin, who everyone thought was on "besties" status with Trump, has ceased diplomatic relations with America. That in itself will likely amount to nothing; it is not Russia's first time they have put American on time-out. But, now Trump is steaming an attack fleet off to North Korea just days after speaking with China's Xi. Xi has deployed 150,00 troops to the border of North Korea and my thinking is they are not there to welcome immigrants with open arms. Instead, it is just the opposite. The troops are there to prevent a mass exodus from the rogue nation to China. China believes there is going to be a reason for North Koreans to move like that; they are likely to be fleeing hastily. This sounds alarming. Markets do not like alarming situations. The USDJPY is acting like that alarm is a full-on red alert. More moves in JPY will come.

North Korea says it is ready for war with the United States. I am not certain that something like that will happen. This may be nothing more than a show of force. Cooler heads would certainly need to prevail. If America pulled off a tomahawk missile strike on North Korea, much as they did with Syria, the backlash would be far greater. North Korea would retaliate against South Korea in seconds. The word "ugly" would not even begin to describe what would happen.

In the meantime, both Trump and Kim Jong-un are sabre rattling the best they can. Kim has even threatened nuclear retaliation if the United States attacks in any manner. Again, I do not see any attacks happening. But, there is no certainty in any kind of way whatsoever.

Japan has been in a massive program to lift its economy out of a decade's-long stagnation. The process of Quantitative Easing (QE) involves the Bank of Japan (BoJ) purchasing government debt. When a central bank does this it in essence prints money. The purchases are not done through open operations but instead the central bank buys these assets off of member banks. When this process happens, the central bank credits the member banks deposits. The banks are then free to use those assets to loan out money in the hopes of stimulating the economy.

But, that is not what happens in real life.

Money abhors a vacuum. It is always looking for an opportunity. If you were a bank and had extra reserves, exactly like the process just described above where the BoJ has provided a massive amount of reserves to its member banks, you would want to find the very best opportunity to invest those funds. In Japan, the interest rate on the government's benchmark 10-year loan is a paltry 0.03%. This is in the target range the Bank of Japan has for this yield. In the United States that comparable rate is 2.30%.

A bank, or a person, for that matter, could effectively borrow money in Japan for nearly 0.0% interest and stick those funds into a bank in the United States and earn the difference between the two interest rates. That happens all the time in the FX market. It is called the carry trade simply because of the fact that interest on a position in FX is either paid or deducted from an account if the trade is "carried" over to the next business day. This happens at the end of business in New York; it is called "the Fix". If you were long the higher interest rate derived currency versus the lower interest rate derived currency you are paid the differential. If you are short the difference you pay the differential.

Massive amounts of money are plowed into this trade simply because, all else equal, the trade is a no risk trade. However, no trade is ever "all else equal". The variable is the currency exchange. Those massive funds are driven by mathematics, the "Quants" of the game. The price of the exchange between the currency and the interest received is all played into the trade. The trade anticipates a widening of the interest rate differential. As the chart above shows, interest rates in both countries are heading lower and lower.

It is important to note that Japan's interest rates are 0.03% whereas the rates in the United States are considerably higher at 2.30%. The big thing there is that interest rates in America have a lot further to potential drop versus what is plausible in Japan.

One thing that pushes interest rates a great deal is market participants moving from equities to bonds on a flight-to-quality drive. This is happening and I believe that the events that are precipitating this move are growing quickly.

I just wrote about how I am bearish on the economy of the United States. I believe the stock market is going lower based upon the lack of the ability for the administration to deliver key economic stimulus to propel the economy beyond its moribund growth rate. Take away the potential for tax breaks and the market takes out the pricing they pushed into the market. That alone will cause participants to move out of the equities and into the bond market. I believe this problem is going to be far larger than most want to believe.

But... Since that last article a lot more has occurred. Now, there is the threat of military action in North Korea. Again, I just think cooler heads are going to play out; there is far, far too much at risk here. But, the market is nervous and money is moving into bonds.

The USDJPY has moved lower due to the deteriorating interest rate variables. As interest rates move lower and lower, USDJPY will follow. But, it is far from linear. A small move in interest rates could translate into a large move in USDJPY. And, a large move in interest rates could translate into a massive move downward in USDJPY. The carry trade is measured in the trillions. If participants start moving out in large numbers USDJPY could break to lows not seen in a few years.

Again, I would like to think that a whole bunch of smart people ar in the same room as Trump while the planning for what may, or may not, happen. I do not think there will be a large military action. What is interesting is that if the events play out without any blood-shed of any kind, there would not be a fast move back into the carry trade. Remember, there is more than one variable to this: The U.S. economy is slowing. Interest rates are not going higher.

But, ther is likely to be a bottoming of this move. USDJPY has broken down just below 110.00. I am targeting 107.50 to get out of a trade I have on. But, if events in North Korea get ugly, I will be targeting sub-100.00. But, if there is any kind of bloodshed, 100.00 would just be a stopping point towards something much lower.

For now, until certainty comes back into the market, USDJPY is going lower. The economy needs to show sings of improvement and stability in a few regions needs to prevail. Until that happens, I am going short on the carry trade. It will fall apart.

Disclosure: I am/we are short USDJPY. 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.