1 Big Reason The USD/JPY And FXY Aren't 10% Weaker

Includes: FXY, UDN, UUP
by: Michael Sankowski

The most startling development in currencies for 2012 is the move weaker in the USDJPY and FXY.

The move weaker for the yen was sudden, shocking and happened over just 6 weeks. The Bank of Japan announced an new inflation target of 1%, a startling move because Japan had targeted zero inflation for decades.

The yen responded with a huge, one way move. The yen lost almost 1% per week.

Then the fall stopped. The fall in the Japanese Yen came to a dead stop on March 14th.

Since March 14th, the USDJPY has batted back and forth. Why did it stop, after such a dramatic move? Well, there is one big reason: China was unhappy with the pace of the weakness in the USDJPY.

At this point, a quick recap of the important news of the last few months would be helpful.

  1. Japan announces an inflation target of 1% on February 14th.
  2. Japan and China announce a deal for Chinese debt on March 14th.

On February 14th, the Bank of Japan shocked nearly everyone* with an announcement it was shifting the inflation target from 0% to 1%. (*This did not shock everyone. Look at a chart of the yen. The move up started on Feb. 2nd, before the announcement. The yen went straight up for 10 days. This announcement was leaked.)

Then on March 14th, Japan announces they reached an agreement with China to buy Chinese government bonds. This should be further weakness for the yen.

Oddly, March 14th was the low for the yen against the U.S. dollar.

Here is the problem: These announcements and deals were too successful, given the current economic situation in China. The agreement weakened the USDJPY too quickly.

China faces an economic slowdown, and does not want to end up with low growth and the unhappy citizens low growth brings with it.

The solution to that "problem" is to slow down the fall in the value of the Yen. And that's what happened.

It's good to remember the USDCNY exchange rate is managed by China every day. The Yuan has a floating peg against the U.S. Dollar. China allows some growth in the value of the CNY, but the changes in the value of the USDCNY are tiny compared to free floating currencies like the USDJPY.

This means if the U.S. Dollar gets stronger against another currency, the Chinese Yuan gets stronger too. If the Yen falls in value against the U.S. Dollar, it's also falling against the Yuan.

China uses exchange rates as a major policy tool for boosting growth or slowing inflation. The last few weeks provided some indication China faces an economic slowdown.

China is slowing growth just a bit, and it's clear to everyone. China would typically respond to economic slowdown by slowing the rise in the value of the Yuan.

My thinking is the fall in value of the JPY was expected, but the speed it happened was just too much, too soon for China. The initial fall in the USDJPY was expected by China, but now we know where the USDJPY becomes "too weak" for China. It's 84.15 USDJPY.

At 84.15, the USDJPY is very close to the weakest levels it's been in the last 18 months. China is worried about their growth slowing, so adding the pressure of increased price competition from Japan is not something China wants right now.

This is not to say the USDJPY can't or won't go higher (meaning the Japanese yen can get weaker against the USD). I still think there is plenty of room for more weakness in the yen against the USD and the EUR due to the new commitment to a 1% inflation rate.

In fact, there is a flag formation in the USDJPY, and this formation gives a target of at least 86.50. On the weekly chart, the formation gives a target of nearly 90.00

Still, keep in mind China prefers moderation in exchange rate level changes, and they are facing a bit of an economic slowdown. Even if the yen does weaken in value, I expect the China to "increase their reserves of Japanese yen at attractive prices".

So while the USDJPY might rally more (implying a fall in the value of the yen) keep in mind China will not want this to happen either too quickly or with a high level of volatility.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.