2016 has experienced a particularly rocky start, marking the worst financial market reopening for equities in history as concerns about the global economy dent risk sentiment. Major global benchmarks have all found themselves on the defensive as a sell-off that began in China circles the globe. While in many ways this could be a reflection of investors reallocating funds thanks in large part to the shift in Federal Reserve policy, several indicators such as the USD/JPY pair suggest that haven flows are growing amidst the uncertainty. Pressure on risk-assets looks likely to persist as investors reduce exposure to higher yielding assets in preference of safety assets. The flight to quality over yield has taken several forms, but the most notable has been the spike higher in gold and move lower in USD/JPY. The USD/JPY carry-trade in particular gives many good insights about the outlook.

The Fundamental Perspective

When the Bank of Japan lowered interest rates to record lows back in the early 2000s, the Yen quickly became a very prominent funding currency for trades. The idea of a carry-trade is to borrow money in a lower yielding currency and invest the proceeds in a higher yielding currency. Carry-trades in general were viewed with great promise by investors looking to lock in the interest rate differential, using the trade to fund other trades in different asset classes. However, at the first sign of any trouble, the USD/JPY pair has historically served as a strong barometer for risk sentiment of investors, like a canary in the coalmine warning of imminent danger. In the wake of the last financial crisis of 2008-2009, the Yen strengthened dramatically versus peers, serving as a precursor to losses in major equity benchmarks such as the S&P 500 and Dow Jones Industrial Average.

With conditions worsening in Japan strongly symptomatic of slipping international trade and a weak outlook, investors are once again fleeing to perceived safety as evidenced by the uptick in gold and unwind of the Yen carry-trade. The rout that began late in December as traders were taking profits and adjusting portfolios for year-end purposes quickly accelerated last week, with USD/JPY falling below the key 120.00 level. Policymakers in Japan are far from lofty inflation targets and have been reluctant to add further monetary stimulus in the form of added quantitative easing, adding fuel to the fire. Knowing full well that the world economy is facing serious challenges, the move to not expand asset purchases to stoke inflation looked wise amid the risks. However, as a result, the Yen has gained tremendously versus the dollar.

Should major advanced economies tip back into a recession, it could accelerate selling in the USD/JPY pair, marking a harbinger of times to come for other risk-asset classes. Reduction in risk across the board is highly indicative of investor risk sentiment that is viewing the outlook with increased scrutiny after a nearly 5-year unchecked bull market. It also marks a readjustment after the removal of extremely accommodative Central Banking measures in the United States. The move towards less support and intervention in financial markets could see more recent bubbles such as overextended equity valuations correct very swiftly. Even the outlook for the dollar is strong considering the Federal Reserve tailwinds, it does not necessarily mean upside for USD/JPY. The opposite is true as investors unwind risk-taking positions in favor of risk-aversion in precious metals and other haven assets.

The Technical Perspective

As a strong indicator of risk sentiment amongst investors, the direct correlation between USD/JPY and equities is uncanny. If anything, price momentum in USD/JPY should be viewed as a precursor to moves in major US equity benchmarks, trading stock indices as a secondary play to underlying movement in the USD/JPY pair. Apart from the correlations, the recent move lower in the pair looks slightly exhausted, with the relative strength index trading near the bottom of the range in a sign that the pair is oversold. Present levels could be a strong signal of an upside rebound of between 200-400 pips depending on the scale of a technical rebound, necessitating Call positions targeting between 119.50 and 121.00.

While near-term the USD/JPY looks poised for a technical bounce, the 50 and 200-day moving averages remain trending above the pair in a sign that both levels are acting as resistance to any prolonged upside. The 50-day moving average also happens to coincide with key resistance at 121.60 and is presently about to cross the 200-day moving average to the downside in what is normally viewed as a very bearish “death cross pattern.” Any near-term bounce should be used as an opportunity to establish Put positions targeting key support at 116.05. A break below this critical level paves the way for a deeper correction in USD/JPY towards 110.00 over the medium-term.

Conclusion

The unwinding of the USD/JPY carry-trade has several implications for global financial markets. Recent price action could be early indications that the health of the global economy is faltering, a trend that is manifesting itself in a “risk-off” attitude amongst traders as they seek to trade yield for relatively safety. Increased flows into the Yen will probably also serve as a precursor to losses in stocks as risk sentiment wavers. The Yen may appear slightly oversold at present based on the pace of recent downward momentum, however investors can take advantage of any bounce with Call positions. Conversely, investors can wait for an optimal entry point for Put positions with expectations that USD/JPY will drop back towards 116.05 and beyond in the coming weeks. The broad confluence of fundamental and technical factors mean the medium-term outlook for USD/JPY is bearish considering the recent reversal lower and headwinds to sustained upside despite the prevailing long-term uptrend.