USD/JPY Jittery Ahead of Bank of Japan Decision

With the Yen’s future hanging in the balance, financial market are looking increasingly nervous heading into the pivotal Bank of Japan decision set to be released Wednesday. With falling trading volumes heading into the announcement, market participants are caught between extremes. On the one hand, there is room for positive surprises, especially if the Central Bank opts to be more aggressive than even the most optimistic analyst expectations. However, based on the shrinking central banking toolkit, the possibility of disappointment is also significant. It is that very disappointment in existing policies which has seen the USDJPY trend lower over the last year despite the highly accommodative policy strategy already undertaken. As the Bank of Japan pushes the limits and boundaries of monetary policy, the outlook for the Yen hangs squarely in the balance, longingly awaiting the unveiling of its fate.

Dwindling Options

After establishing a significant footprint in the Japanese sovereign bond market along with REITs, ETFs, and other equities, the main problem facing the Japanese central bank is the decreasing availability of assets to buoy its epic quantitative and qualitative easing program. Although traders short the Yen are hoping for a big expansion of the existing QQE program with another JPY 10 trillion in purchases, a falling supply of assets may make this impossible. Furthermore, more asset purchases can create problems that effectively hurt the banking sector by driving rates deeper into negative territory, collapsing net interest and lending income. One of the proposed ways to fix this development is by instituting a “twist”.This would mean focusing on short-term debt instead of buying longer-term debt in an effort to keep long-term interest rates positive.

At present, the best course forward would be a combination of lowering interest rates to spur consumption and twisting the balance sheet maturities to protect the banking sector. However, even with these ambitious strategies available, the Bank of Japan’s outlook is fraught with difficulties, namely an appreciating Yen and ongoing deflation.If they believe they will be unable to significantly weaken the Yen with new policy measures, the 2.00% inflation target may remain out of reach for years. However, at a time nearly all central banks of advanced economies are easing policy, the effectiveness of Japan’s own accommodation is running into headwinds. Although deeper cuts to interest rates are the obvious move, markets have already likely factored in this possibility, potentially causing any adjustment to ultimately backfire. Unless the Bank of Japan can really surprise markets tomorrow, the chances of weakening the Yen without direct intervention are dimming.

Technically Speaking

Even with the looming potential of a massive shock after the Bank of Japan decision, volatility in the USDJPY pair has shrunk considerable over the last few sessions, indicating that a directional breakout may soon be in the cards. Typically speaking, a breakout or reversal that results from a price consolidation process is preceded by falling volatility and volume, two factors that are both present as market participants cue up for the Central Bank announcement. On a medium-term time frame, support at the key 100.00 psychological barrier is providing the basis for a descending triangle pattern. Generally, this setup is viewed as bearish, with a breakout occurring in the event of a candlestick close below support. However, if the prevailing downward trend line is broken to the upside, it signals the breakdown of the pattern and could be an early indicator of a trend reversal.

Acting as resistance against any prolonged rally to the upside are both the 50 and 200-day moving average. The 200-day moving average continues to trend lower, well above the price action, but the 50-day moving average coincides with the upper line of an equidistant channel formation that has been intact for the better part of the last year. While normally the ideal strategy for trading a channel would be establishing positions at the upper channel line targeting the lower channel line, a candlestick close above the upper channel line could be a breakout sign, especially if the move is accompanied by higher volatility and trading volumes. With so much at stake and the heightened possibility of a more extreme than predicted policy move, getting aggressive with the prevailing trend may not be the best available strategy, especially with USDJPY hugging the upper channel line and the 50-DMA.