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USD/JPY: Downside Risk Remains For 2020

by: Hedge Insider
Hedge Insider
Long/short equity, value, macro, volatility

USD/JPY is recently attempting to break its medium-term trading range, but evidently failing.

In line with an apparently bearish trend that began at the start of October 2018, USD/JPY is likely still subject to downside risk, in spite of its 'positive carry'.

The interest rate spread (i.e., the carrying value) of USD/JPY remains positive, perhaps even slightly pessimistic, but roughly in line with central bank rates. Yet the spread has been falling.

This fall has presented a divergence with USD/JPY spot prices, signaling the potential for downside in the FX market for USD/JPY, as interest rate differentials and FX spot prices typically correlate strongly and positively (divergences tend to be closed).

Further, a recent rise in the ratio between gold and copper prices would possibly provide us with another risk-off signal, which would strengthen our bearish thesis on USD/JPY (or at the very least, strengthen the possibility of a global risk-off move which could result in both USD strength and JPY strength).

In a recent article of mine, published December 22, 2019, I drew attention to the potential near-term downside risk for the USD/JPY pair. The downside risk was signaled by the bond market, as the one-year interest rate spread for USD/JPY (i.e., the difference between the one-year government bond yields of the United States and Japan) had clearly diverged with USD/JPY spot prices.

In the article referenced, I produced the following chart, which clearly showed this divergence (the red line being the interest rate differential, set against the vertical y-axis).

One-year Interest Rate Spread for USD/JPY

(Chart created by the author using TradingView. The same applies to subsequent candlestick charts presented herein.)

An updated chart is shown below. The shaded area represents the same medium-term trading range as illustrated in the chart above; however, notice the recent downside as the USD/JPY has sunk back into the trading range (in spite of recent and apparently ongoing breaches to the upside).

USD/JPY vs. Trading Range

Nevertheless, in spite of USD/JPY falling into January 2020, spot prices have climbed back up to just above the top of the range. Our target (highlighted by the horizontal blue line in the chart above), which is the midpoint of the pair's trading range, was ultimately avoided given the recent upside.

However, the same signal as before continues to suggest downside. The chart below is updated to include the one-year spread for USD/JPY (again, using short-term, one-year government bonds as a proxy for the carrying value of the pair).

USD/JPY vs. One-year Interest Rate Differential

Interest rate spreads typically correlate not only positively but also strongly with FX spot prices. You can see this on the left side of the chart above; only on the right side do we see the correlation break down. The typically tight correlation is because interest rates, which are at first set by central banks (which then subsequently translate into borrowing costs in the real economy, including the price of leverage, etc.), dictate the carrying value of currencies relative to others. The higher a currency's interest rate, the more attractive it becomes to hold.

As we can see in the chart above, USD/JPY safely remains a positive-carry pair (the far-right y-axis shows the most recent daily closing value as being +1.65%), in spite of recent downside. This pair therefore continues to remain in favor of upside longer term, from a carry-trade perspective; however, the recent divergence is important and could indicate risk-off sentiment from the bond market.

Sentiment is crucial for USD/JPY. The Japanese yen is viewed as a safe-haven currency, owing to Japan's positive current account surplus (which provides the yen with some consistent level of support, as by definition it means that the Japanese economy is exporting a greater value of goods and services than it is importing). The Japanese investment community is also significant, as with negative rates domestically (see here for a comparison of central bank rates), Japanese investors have an incentive to sell the yen and purchase higher-yielding currencies and/or assets (U.S. equities, for instance).

When stocks fall, USD/JPY tends to fall, and vice versa; bullish sentiment tends to fuel upside in USD/JPY. The fact that the USD/JPY pair is currently ignoring the direction of the bond market is a little concerning, and thus we should not rule out more downside volatility, and that would especially apply if there is equity volatility. Equity volatility (and usually downside volatility) can spark the unwinding of 'carry trades' (including short-JPY/long-USD trades), sending capital back to safe havens like Japan and thus strengthening the yen.

The bond market's current one-year spread of +1.65% for USD/JPY would compare to the difference between the central bank rates of the U.S. and Japan of +1.73% (that is, if we take a midpoint from the U.S. Federal Reserve's target rate between +1.50 and 1.75%, of about 163 basis points, and subtract the negative 10 basis points which represents the Bank of Japan's short-term rate). The bond market on this basis would appear to be modestly pessimistic, but still roughly in line with central bank rates.

Nevertheless, if we 'zoom out' of our prior chart, we can see that while divergences between the direction of the bond market and FX spot prices can happen, the gaps usually do clear. At the moment, further upside is probably to be limited, and sharp downside volatility is still a conceivable prospect.

USD/JPY and Bond Market Divergence

I would also draw attention to the 100-day simple moving average (the 100 SMA). The chart below shows this moving average (per the smoothed black line, on the main body of the chart), while the bottom panel of the chart shows the distance between the current price of USD/JPY and the 100 SMA (the blue line is set at zero; i.e., you can clearly see that the pair is currently above its 100 SMA).

USD/JPY vs. 100-day Moving Average

However, we can also see that the pair (per the bottom panel in the chart above) is struggling to sustain itself above the 100 SMA. With lower highs and lower lows in the near term, at least in terms of the distance between the spot price of USD/JPY and its 100 SMA, we could well see a break-down underneath this, and a return of the mostly bearish trend which has persisted since October 2018.

Indeed, the chart below draws attention to the fact that the price of USD/JPY has recently attempted (and failed) to breach the top of what could be a bearish-looking channel which began at the start of October 2018.

USD/JPY Bearish Trend

One would be wise not to trade on trendlines, as these are not based on fundamentals. Nevertheless, in light of the bond market's seemingly negative signaling as of recent, and this pair's weakening struggle to sustain itself above the 100 SMA, a simple maintenance of the status quo from the Federal Reserve and Bank of Japan (which the market would appear to support, as the bond yields are actually not of significant distance from short-term central bank rates) could see the USD/JPY pair weaken in the near term.

This would not be a trade recommendation per se, especially considering both the USD and JPY can serve as safe havens in times of market distress (i.e., if risk sentiment weakens, it is possible for USD/JPY to stay flat, as the demand for both currencies increases, not just for the yen). However, short-term JPY strength could certainly be possible.

If JPY strength were to occur, this would indeed traditionally be interpreted as a risk-off signal (usually accompanied by, and/or driven by, a sell-off in risk assets such as U.S. equities). We would also, however, usually see weakness in commodity currencies such as the New Zealand dollar (the NZD). I have written recently on the NZD, with a bearish outlook. In this author's view, there is a good chance that a confluence arises in which we see USD and JPY strength in the near term (both serving as "safe havens", so to speak), with accompanying weakness in commodity currencies such as NZD.

Also note that, as shown in the chart below (which is indexed to 100), the ratio between the gold price (in U.S. dollars) and the copper price (in U.S. dollars) is recently breaking out to the upside. If this rises further, this could strengthen our risk-off view, as gold is traditionally viewed as a safe-haven, risk-off asset, while copper is associated with improving global economic conditions and world trade (i.e., "risk-on").

Gold-to-Copper Ratio

In any case, the USD/JPY would appear to be a risky trade on the long side, at least in the short term.

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.