Japanese Yen Poised to Gain Further For Three Key Reasons

The Japanese Yen heads into the end of 2016 trading near multi-year highs versus the US Dollar, and economic developments suggest the JPY may finally break the ¥100 level before the year is through. Continued inaction from both the Bank of Japan and the US Federal Reserve represents the biggest risk to the USD/JPY exchange rate. Other key risks are the rise of trade protectionism and financial market volatility. And indeed, the status quo suggests the USD/JPY will likely fall further until we see major changes.

Year of “Great Divergence” Proves a Big Disappointment, Yen Rallies Accordingly

It was supposed to be the year of “the great divergence” in monetary policy as the US Federal Reserve would raise interest rates while the Bank of Japan and other global counterparts went in the opposite direction. Suffice it to say the Fed did not hold up its end of the bargain—it hiked rates once at the end of 2015 but failed to match market expectations for further moves through 2016. This fact helps explain why the US Dollar posted its worst nine-month performance versus the JPY since the Global Financial Crisis. And indeed, comparable disappointments from the Bank of Japan put further downward pressure on the yield-sensitive USD/JPY exchange rate.

The Bank of Japan started the year in fairly dramatic fashion as it cut its benchmark interest rate into negative territory, but the BoJ went on to disappoint those looking for further monetary policy easing through the rest of the year. This fact is especially surprising given that National Japanese Consumer Price Index inflation figures showed the country re-entered deflation through the first quarter. It was almost humorous to note the Bank of Japan forecasted inflation would hit 1.7 percent in 2017 while the median private forecast pointed to 0.9 percent growth. Officials finally posted a dramatic cut in inflation and growth forecasts at their July meeting, and further policy easing seemed inevitable.

Yet the BoJ would not meet market expectations for a straightforward reason: negative interest rates were producing unwanted side effects and aggressive QQE policy left the bank with little scope for further asset purchases. Kuroda eventually introduced two modest policy changes at the bank’s September meeting—the BoJ would raise its inflation target above 2.0 percent and put a ceiling on 10-year Japanese Government Bond yields. The first seems unlikely to have any real difference on market expectations given that the BoJ has thus far proven unable to achieve its existing inflation target. The second was a bit more ambiguous as the BoJ theoretically committed to unlimited QQE purchases if yields approached the stated ceiling. JGB yields are nonetheless below the official ceiling and the statement effectively calls for unchanged policy through the foreseeable future. We thus enter the final quarter of 2016 with the status quo firmly intact, and this favors a continuation of USD/JPY declines.

Politics to the Fore Ahead of United States’ Presidential Elections

One typical risk to betting on the Yen (betting against USD/JPY) is Ministry of Finance intervention, and that seems an especially big risk as the USD/JPY approaches ¥100 .Yet obvious international political pressure may limit the MoF’s ability to make a substantive difference in the currency’s trend.

Japan stands to gain if the United States’ Congress and President approve the much-heralded Trans-Pacific Partnership (TPP) trade agreement. Anti-trade sentiment has nonetheless come to the fore ahead of the US Presidential Elections in November, and ratification of the TPP is far from certain. Aggressive currency manipulation from the Japanese Government could further raise the ire of the US politicians and effectively kill the TPP in its tracks. The Japanese MoF has certainly warned it could intervene if the Yen continues to strengthen, but these political calculations make those threats considerably less credible. Failure to act would clear the USD/JPY to break and stay below ¥100.

Will Markets Cooperate with the Japanese Yen?

The final wildcard for the Yen is not limited to Japan but especially relevant for its currency: will global financial markets remain stable? The near-term correlation between the USD/JPY exchange rate and the US S&P 500 Volatility Index (VIX)—also known as the “fear index”—recently hit its strongest in two years. The correlation has admittedly been volatile, and the USD/JPY shows little link to the VIX when the VIX is low. The fact the JPY surges (USD/JPY declines) when the VIX spikes higher helps to highlight the fact the Yen tends to strengthen in times of financial market turmoil. The recent jump in S&P volatility coincided with Yen strength, and any similar episodes of sharp S&P declines would also likely coincide with JPY gains.

Correlation between USD/JPY and US S&P 500 Volatility Index Strengthens

Data Source: Bloomberg. Chart Source: R

It is important to note that the reverse is not necessarily true; quiet markets may not produce USD/JPY strength. Thus it seems volatility is a uniquely lopsided risk for the Yen.

The combination of volatility risk and other fundamental factors leave us bullish the Yen (bearish USD/JPY) through the foreseeable future. Our technical picture highlights the risks below. - DR

Technical Analysis: Rally Targeting Structural Resistance- Pullbacks to Be Viewed as Opportunity

USDJPY Monthly

USDJPY responded to a critical support confluence in the second half of the year around the 101-handle (100.71-101.26) – this region is defined by the 50% retracement of the 2011 rally, the 1999/2000 lows, former trendline resistance extending off the 1998 & 2007 highs and a median-line extending off the 2009 lows. The exchange rate could not register a weekly close below this mark and as of 12/20 the subsequent rally has marked the largest quarterly advance since Q3 1995 and the largest quarterly range (ATR) since Q4 of 2008. If this was just a zoom & retest of the 2014 breakout, the broader outlook would remain constructive while above this key threshold heading into 2017. Note that a parallel extending off the 2013 highs converges on the June high and highlights possible near-term support at 111.45.

USDJPY Weekly

The focus heading into Q1 is on a key resistance confluence at 120.18-121.12 where the 2016 open converges on the yearly high-week close, the 78.6% retracement of the 2015 decline, the upper median-line parallel of the embedded ascending structure and basic trendline resistance off the 2015 high. The current rally is at risk heading into this region and we’ll be looking for a pullback to offer favorable long-entries while above confluence support at 111.45.

USDJPY Daily

Divergence in near-term price action further highlights the risk for a pullback heading into this key structural resistance barrier (doesn’t mean we can’t continue to rally for a few more weeks). Interim support rests at 115.52-116.08 backed by 113.80 & 111.45- areas of interest for possible exhaustion / long-entries. A breach above confluence resistance targets subsequent topside objectives at 121.69, 122.77 & the 2015 high at 125.85. Bottom line: while the immediate focus is higher, the long-bias is vulnerable heading into the start of the year / key resistance and we’ll be looking to fade weakness while within this structure off the yearly lows. A breakout of this formation would likely to see accelerated gains for the pair towards previous yearly highs and the broader median-line formation extending off the 1995 lows (~127-128).