USD/JPY Downside Risk Heightens

by: Hedge Insider

USD/JPY has fallen quickly recently, from as high as 109.300 at the start of August to the current price of 105.684 (after hitting lows of 105.267).

The downside potential for USD/JPY remains strong. However, for now, the pair is likely to stabilize, favoring a short-term consolidation between 106.000 and 106.300.

However, we will need to watch the yield differential (between short-term U.S. rates and Japanese rates), and USD/JPY price action, to ensure that this will occur.

If USD/JPY cannot consolidate in the 106.000 to 106.300 region, risk-off activity will likely pick up, just as the safe-haven currency (that is the Japanese yen) has captured the attention of markets.

The USD/JPY pair has dropped precipitously recently, with a flight to the Japanese yen. The yen apparently continues to prove its safe-haven status. The U.S. dollar is also viewed as a safe-haven currency. Yet it is a true risk-off signal when USD/JPY falls, indicating a flow out of the United States, and by connection, U.S. risk assets (including equities).

The yen is viewed as a safe haven for a few key reasons. Firstly, Japan runs current account surpluses (see chart below from

Japan Current Account Surpluses

Current account surpluses provide the yen with a strong foundation; you can view this as a fundamental, trade-based "tailwind" of sorts (occurring when exports exceed imports), providing support for the demand for yen in the long term. The yen is also liquid (well-traded) and has come to be viewed as a reserve currency of sorts among Asian countries.

Additionally, more recently, the market appears to acknowledge that the Bank of Japan has far fewer tools to ease than other central banks like the Federal Reserve. With negative rates prevailing in Japan already, the market seems to view the downside risk, in terms of a break-down in yield differentials, as generally limited. Negative rates would need to go even further into negative territory, which is probably unlikely at this stage, as it would surprise the market and potentially jeopardize the credibility of the Bank of Japan.

Risk-off events also occur with the yen at center stage given that many retail (and institutional) investors in Japan own assets abroad, and they are not necessarily hedged. When assets such as U.S. equities tick down, this can spark a wave of selling and a flight back to the yen. Sometimes this flight to the yen occurs prior to a sell-off, serving as a useful leading indicator for risk-off activity from a trader's perspective.

More recently, U.S. equities and the USD/JPY pair have fallen in sync, as the chart below shows.

S&P 500 Futures vs. USD/JPY (Chart created by the author using charting tools. The same applies to subsequent charts presented herein.)

As the chart indicates (with USD/JPY shown by the red line), USD/JPY has been declining since hitting its 2019 high in late April 2019 of roughly 112. More recently, the pair is trading between 105 and 106. This substantial decline was mostly ignored by equities, although some of the decline was met with a large sell-off in equities through May 2019.

What's interesting is that the USD/JPY decline continued unabated, while equities climbed back up. Now, with USD/JPY declining even faster, equities have finally given in to this global macro pressure. Unless the Japanese yen crosses (currency pairs) can firm up, the pressure on equities could mount quickly.

In my view, the Japanese yen is likely to firm up a little in the short term. On the upside, I view the following levels as likely targets for consolidation: 106.000, 106.300, 106.430, and potentially 106.560. If the USD/JPY pair strengthens considerably, it could hit 106.700 in the short term; however, that is a considerably lower-probability outcome at this juncture.

The downside is potential is concerning. There is a long way for the pair to fall. The flash crash low (set on January 3, 2019) of 104.656 could be met, for example. But this was a freak event; not a key level of support. A closer inspection of past levels in history (that were more firmly traded) would suggest that 105.320 would be a first target (close to Friday's close on August 9, 2019, of 105.684). This would then open the gate up to 104.760, and finally 104.480 (below the flash crash low). The pair could also later see 104.050.

I have plotted the levels above in the chart below, using green lines to indicate the higher levels, and red lines to indicate the downside levels. The levels were generated using volume profile analysis (key areas of support and resistance, based on the most firmly traded levels by tick volumes in the past).

Key Levels for USD/JPY It is important for the USD/JPY pair to consolidate above (in the region of the prices indicated above, in green) for markets to function without excessive risk-off activity. A stronger flight to the yen (to the prices indicated above, in red) would likely send equities cascading lower, precipitating a wave of further selling.

I view the case for a consolidation here as more likely than the pair cascading quickly lower. However, I will leave you with a warning: if next week does not see USD/JPY hitting at least 106.000, and ideally 106.300, risk assets such as U.S. equities are likely to take a strong turn for the worse. A consolidation in the range of 106.000 to 106.430 in the short term, however, would likely do well to soften the recent risk-off activity.

Short-term rates will also be important to watch. The chart below shows the one-year spread between U.S. and Japanese rates. While this has declined over recent weeks, we are seeing a light tick-up in the spread as the market consolidates its U.S. rates expectations. If this spread can continue to firm up and remain above 2% (currently 2.032%), USD/JPY is likely to improve somewhat.

USD/JPY vs. One-year Rate Differential However, a further drop in the spread would support further downside in the USD/JPY pair. For now, we need to watch USD/JPY price action, short-term U.S. and Japanese rates, and also U.S. equity futures for further signals.

Disclosure: I/we 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.