Japanese Tumbles then Surges - Pivotal Week Ahead

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Japanese Tumbles then Surges - Pivotal Week Ahead

Fundamental Forecast for Japanese Yen: Bearish

The Japanese Yen came within a hair’s width of the critical ¥100 mark against the US Dollar (ticker: USDOLLAR), once again posting the worst 7-day performance of any major currency two weeks after the Bank of Japan embarked on hyperactive Quantitative Easing measures.

A sharp Friday rebound caught markets by surprise as the JPY was actually the best-performing currency the final 24 hours of the week’s forex trading, and the violent nature of the move gives us pause in our otherwise bearish JPY forecasts. The argument is simple: an impressive decline in Japanese Government Bond yields will lead domestic investors to shift their savings to higher-yielding currencies abroad. In other words—don’t fight the Bank of Japan as they do everything in their power to boost inflation and weaken their domestic currency.

Relatively limited Japanese economic event risk in the week ahead could potentially make for quiet JPY trading. But FX Options markets remain positioned for big Yen moves as traders are paying the highest prices for volatility since 2011. A look at cross-market correlations indeed shows that the biggest JPY driver as of late has been JGB yields; an outright meltdown in bond yields post-BoJ helped drive the Yen lower across the board.

The prices of volatility on Japanese Government Bonds have nonetheless surged to 10-year highs following de facto BoJ intervention, and one source reports that the surge in vols may have unintended consequences for the central bank. Japanese financial instutitions must limit their Value at Risk (VaR) according to the volatility in their asset portfolios. The surge in JGB volatility may actually force them to sell bonds and push yields higher—the exact opposite of what the Bank of Japan attempts to accomplish via QE. It’s admittedly a stretch, but the Friday rally in the JPY (USDJPY decline) did coincide with an important jump in JGB yields.

A late-session release of the US Treasury Currency report added a further twist to the day’s developments, as officials said they would “closely monitor Japan’s currency policy” as “Japan should refrain from competitive devaluation.” The risks of an all-out “currency war” grew as US officials expressed quite clear displeasure with the Bank of Japan’s aggressive attempts to weaken its currency.

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Overall price action on Friday left markets in a daze. The US Dollar swung sharply in both directions versus the Euro, gold prices saw their biggest single-day decline in over a year, and yet the Dow Jones Industrial Average finished almost exactly flat. We would expect such a sharp sell-off in commodity markets to coincide with a material Dollar bounce, but it didn’t. Instead the Dollar put in middling performance and in fact weakned notably versus the previously-downtrodden Yen.

Uncertainty runs high ahead of a potentially pivotal week of price action, as cyclical evidence suggests that the Euro/US Dollar and Euro/Japanese Yen pairs could see key inflection points in the coming days. High volatility in both the Yen and JGB’s warn of outsized moves in the immediate future. And though time studies can often help pinpoint key reversal points, they don’t necessarily tell us in which direction we can see markets break. In other words—remain nimble.

In the face of high volatility expectations, we continue to favor trading our volatility-friendly Breakout system until further notice. Yet recent choppiness emphasizes that this is not the time to be over-leveraged in FX trades. Our overall bias favors continued Yen weakness, but we’re also acutely aware that even the strongest trends must eventually come to an end. – DR

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