Seeking Alpha

Yen Rate Differentials Implicate Risk-On Activity

by: Hedge Insider

Changes in yen interest rate differentials have proven favorable for the yen over the medium term.

Most recently, the yen has weakened and touched its 100-day moving average (vs. the U.S. dollar), while yen rate differentials have started to tick down.

This change of sentiment, which effectively makes the yen cheaper to borrow to fund risk-on activity, is most clear by studying the rolling daily (negative) spread offered by the yen.

With the spread ticking down quickly, it is likely that we see the USD/JPY pair strengthen over the medium term, with a target of 109.000 (notwithstanding the potential for a short-term downside retracement).

The Japanese yen is a good barometer for risk appetite: the stronger the yen, the weaker risk appetite typically is. The yen is often used as a cheap funding currency to finance the purchase of risk assets such as U.S. equities.

I have covered this relationship many times in multiple prior articles. In this short article I will draw attention to how rate differentials are currently shaping up for the yen, and why they might imply yen further weakness to come.

Many factors drive currencies, but one important factor is interest rates. In fact, since interest rates are typically thought to 'follow' GDP over the long run, higher interest rates not only provide so-called carry traders with a higher yield (thus supporting the currency in question), but they also indicate stronger sentiment with respect to the market's longer-term view of an economy. If market-priced rates rise, it would indicate that the market is finding a lower probability of monetary easing (implying a stronger economy).

Nevertheless, while longer-term perspectives are important (including macroeconomic sentiment), this article will take a shorter-term perspective. The below chart of JPY/USD (which is USD/JPY but inverted; to focus on the yen rather than the U.S. dollar specifically) also includes the 100-day moving average (red line) since around August 2018 to present.

JPY vs. USD (Chart created using The same applies to subsequent charts presented herein unless otherwise specified.)

As you can see, the yen is now touching the 100-day moving average. At this point, we now must consider whether it will break the line and find resistance before continuing to drop, or whether it will temporarily break and then jump, or simply jump without a break.

Going back to interest rates: the chart below is an updated version of the above, which also maps the spread of two-year yen rates minus the sum of the two-year rates offered by each of the United States, Australia, Canada, and Germany (using government bond yields as proxies). The net spread is itself not informative, but the trend is, and hence I have added this to a new axis on the far-right; shown by the green line. Note: the green line is a 20-day average, while the running daily sum is indicated at the bottom of the chart.

Japanese Yen Interest Rate Differentials As we can see, as the yen touches its 100-day moving average, the yen's 20-day average global rate differential is ticking down. This means that the yen is effectively becoming cheaper relative to other currencies. This is a bad sign for the Japanese yen.

If instead the 20-day average was rising, I would suggest that the yen could strengthen (meaning the potential for risk-off activity), with a bounce off the 100-day moving average. However, since the yen is becoming less favorable from a rates perspective at this juncture, there is a strong possibility of a break to the downside for the yen.

A weaker yen typically sends risk assets upward, which would mean that equities and other risk assets could do well over the short-to-medium term.

In terms of USD/JPY specifically, we can use similar concepts to the above to estimate the potential for upside (focusing only on two-year rates for the U.S. and Japan).

USD/JPY Chart for September 2019 As you can see, things are looking potentially quite bullish for USD/JPY. I have drawn attention to 107.150 and 109.000 as levels of interest. At the moment, it would appear the USD/JPY pair is looking to break to 109.000; this would likely be bullish for stocks too -- particularly U.S. equities (e.g. S&P 500).

However, given the tight intraday trading range of September 13, 2019 (the most recent day on the chart), the implicated indecision could mean that a retracement to the 107.000 to 107.500 region is one possibility before 109.000 (or higher) is achieved.

Note also that VIX futures have been dropping precipitously recently, practically now under their bottom 20-day Bollinger Band (see below).

VIX Futures (Current Contract) This sort of activity in the VIX usually precedes spikes (which typically translates into downside volatility in stocks and other risk assets), and hence I would watch out for some yen strength first before shorting the yen against the dollar (or similar), i.e before looking to USD/JPY 109.000. There is indeed a risk of 'risk-off' (lower USD/JPY) before we see a return to 'risk-on' (higher USD/JPY), but the medium-term bias would appear to be risk-on (bullish for USD/JPY) judging by the rates-oriented perspective offered above.

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.