USD/JPY Hit By Unwind

One of the most prominent global carry-trades is flashing a strong warning sign to anyone willing to watch.  The Yen carry-trade rose to prominence in the early 2000s as the Bank of Japan was forced to keep cutting rates to avoid deflation, a process that failed to yield results for the Japanese economy.  However, ultra-low borrowing rates did benefit one group of individuals; investors.  Traders were able to take advantage of the low interest rates by borrowing Yen to invest in other higher yielding assets.  Low interest rates also ensured that the Yen would stay weaker and help bolster Japanese exporters.  However, now that the global export economy is collapsing at a near record pace, one of the first areas this shift in fortunes is evident is the Yen carry-trade.

The Fundamental Picture

In the wake of the last financial crisis, the Yen was one of the biggest gainers owing to investors unwinding exposure to carry-trades in 2008 and 2009.  Then came the Tsunami which destroyed the reactor at Fukushima, around the same time as the Yen hit multi-decade highs, crushing the nation’s exports and harming output.  However, coming to the rescue was former Prime Minister Shinzo Abe, promising to get Japan Inc back on track.  His first move when reelected was to install a new central bankers with an affinity for his own self-styled version of policies referred to as Abenomics.  The premise of this new monetary and economic program was reversing the steady decline of nearly two decades of deflation.  Wages had stagnated and moreover, exporters were crushed by the stronger Yen. 

The strategy, in coordination with the Bank of Japan, called for expanded quantitative easing that would focus on the bond market and would later also include a wider berth of assets including real estate investment trusts and equity futures.  The kneejerk reaction was a net positive for the Japanese economy, helping exporters to rebound and enabling the Bank of Japan to meet inflation targets.  At the outset, it was also great for carry-traders.  Japanese interest rates were not set to move and the Yen had climbed to such heights that carry-traders who got in early were unconcerned by the fluctuations in the USDJPY pair, as long as it moved higher. However, recently, the carry-trade has lost a lot of enthusiasm as volatility picks up and Central Bank omnipotence is questioned.

As the Bank of Japan misses inflation targets and quickly runs out of assets to monetize via the qualitative and quantitative easing program, it is becoming quite clear that policymakers are running out of tools to keep the economy competitive.  Adding to the Bank of Japan’s woes is the fundamental situation in the Japanese economy.  Even though unemployment remains near record lows, wage growth is stagnating and once again inflation is trending towards deflationary territory.  The slowdown in the global economy and devaluations occurring in competing countries is eliminating to a degree to the efficacy of the efforts.  Now that global markets are once again experiencing a period of volatility, it is likely that carry-traders are beginning to run for the exits, seeing USDJPY fall from multi-year highs.  USDJPY is a strong indicators for the health of the global economy and the latest moves are signaling risk-off for savvy investors looking to play to the downturn or exit and reenter once conditions improve.

The Technical Take

The Yen has had a tumultuous ride of the last few weeks as global contagion saw risk-assets tumble across the globe, forcing margin calls across asset classes which contributed to substantial capitulation.  After touching multi-year highs back in June, USDJPY touched the lowest levels since January, slumping nearly 800 pips in 5 sessions before rebounding modestly.  After the dead cat bounce, USDJPY has once again resumed the near-term downtrend.  Feeding expectations that the pair is set to give further ground, especially in the wake of a rising probability of the Federal Reserve raising interest rates in 2015.  The pair is currently trending below both the 50 and 200-day moving averages, contributing to further downside pressures in the pair.

Looking at the key technical support levels, 118.47 stands out as the last major pocket of buying before paving the way for a move downwards towards the most recent lows at 116.07.  Barring the recent crash lower, the pair is progressively trending lower in the near-term, setting up in a descending triangle formation with USDJPY consolidating between the downtrend line and 118.47.  As the range tightens and expectations are heightened ahead of the upcoming FOMC Meeting, there is a possibility that USDJPY will experience a downside breakout should the critical 118.47 support level be taken out.  However, if the downtrend line is broken, it could signal time to be spent trending sideways.

 

The ideal strategy for taking advantage of the carry trade unwind remains Put positions initiated on rallies in the USDJPY also known as “fading”.  With this in mind, optimal Put positions are taken above 119.00 targeting 118.47 and 116.07.  However, should the pair rise above resistance at 120.66, it is a good time to evaluate Call positions targeting 121.67 on the upside.  With volatility expected to remain elevated over the coming weeks, especially with the reopening of Chinese financial markets it could potentially see these moves occur intraday instead of taking weeks.  With that in mind, it is important to distinguish between the short-term and longer-term horizon.  Even though the bounce has played out following the earlier slide in USDJPY and short-term prospects remain largely biased downwards, longer-term entry points for Put positions may lie slightly higher.

Conclusion

From both a fundamental and technical perspective, USDJPY has quite the uphill battle if it wishes to climb back towards the 125.00 level.  A resurgence in volatility and downturn in global trade is impacting export economies like Japan, helping to foment one of the worst routs in recent history for the pair.  Even though there was a technical rebound, it quickly fizzled out, adding to concerns that markets are taking a bearish turn.  With fundamentals crumbling and Abenomics falling short of expectations it is no wonder that USDJPY is giving up precious ground and experiencing volatile swings.  With this in mind, the ideal strategy is initiation of Put positions if the pair experiences sharp intraday rallies.  However, should the key near-term downtrend line be broken, it signals that patience is warranted in finding a better entry point.