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Traders and investors perpetually seek a one-look measure that can provide a comprehensive view on the market. While nothing can fully reflect the entire system, USDJPY, especially now, can speak to much of it.
Most retail traders and active investors don’t have a lot of time to do a deep dive into the markets to develop a comprehensive view of the assets in which they intend to trade, much less garner a clear insight of the entire financial system. A lot decide it is best to simply become specialists on a very narrow market segment or to rely on singularly popular benchmarks for which it seems reasonable to extrapolate a full-spectrum view.
Unique Dollar – Yen Qualities
When it comes to a singular market measure, USDJPY has few peers.
The US Dollar and Japanese Yen, the currency pair for trading the dollar against the yen, is the second most liquid currency cross and thereby qualifies as one of the most liquid markets in the world. This reflection on the relative view around two of the world’s largest economies, and the currency cross, offers real insight.
First and foremost, USDJPY is a particularly prominent ‘carry cross’ in the current tightening cycle of global monetary policy. The carry trade involves shorting a low-yielding currency in order to buy a higher yielding currency in an attempt to profit from the interest rate differential. It is the FX equivalent of investing in dividend stocks. The aim is to take advantage of a broader appetite for higher yield differentials between the two currencies. After the Fed’s 75 bp rate hike this month and the Bank of Japan’s effort to keep to its extreme stimulus in a bid to charge domestic economic activity, there remains a strong forecast for interest rate differentials.
As distinct as the USDJPY – and other Yen crosses – is for its carry trade appeal, the yield we are talking about doesn’t offset the full spectrum of risk trends. In other words, if sentiment falters for a traditional ‘risk’ benchmark like the S&P 500 or Dow Jones Industrial Average, it is likely that the exchange rate drops.
Often times, when the relationship between a carry trade and traditional risk benchmark is mentioned, it seems to be treated with textbook-like reverie. In other words, it is accepted on faith that ‘risk on’ means a rise in carry trade and vice versa. The relationship is even more practical and fundamental.
Profound Impact of Japan’s Retail Investors
In Japan where interest rates are extremely low and the Bank of Japan has vowed to keep its extremely dovish credentials through the foreseeable future, it becomes difficult to generate a meaningful rate of return domestically. That pushes local investors to look abroad for a meaningful rate of return. This has become such a profound flow that Japanese investors have started to register in global FX flow reports alongside central banks and governments.
Thus far, the Bank of Japan (BOJ) has vowed to keep its exceptionally accommodative monetary policy in a bid to jumpstart flagging growth. That said, most major policy authorities would like to support growth, but they cannot afford to at the expense of inflation growing out of control. While Japanese central banking authorities likely hope other major central bankers in the US and EU can tame price pressures globally, further persistence in inflation will likely force a change in tack from Japan – just as it did the ECB. Though the European authority attempted to keep its focus squarely on its accommodation effort, inflation pressures pushed the group to lay out a tightening schedule. The Bank of Japan may find itself in a similar boat.
The USDJPY’s sensitivity to risk trends and rate forecasts makes the currency cross a particularly useful macro indicator for arguably the two most prolific themes in the global financial system. There is as much utility from this pair as a signal for broader fundamental themes, not to mention direct trade ideation for the pair itself. One caveat that may dog this cross: the rising risk of intervention.
As USDJPY and other Yen crosses push multi-decade or multi-year highs, the threat of external intervention rises. This is another important feature of the financial system at-large. When macro policy is applied unevenly, it creates extreme pressures that desperate policymakers attempt to solve through dubious policy strategy. I put the probability of stealth intervention (meaning moves that are not officially claimed by the Japanese Ministry of Finance) at a very high level.
Many still stick to the line that a cheaper Yen makes Japan’s exports more affordable for trade partners, so they in turn buy more. The reality is that already globally, high commodity prices paired with an expensive conversion from Yen to other currencies is used to facilitate the purchase.
Keep tabs on USDJPY, and use a speculative anchor to help determine the fundamental focus. For example, if USDJPY rallies higher but risk trends are off in a session, there is a good chance that the interest rate focus is catching traction. As with all indicators, this is merely a tool to overlay on the markets. Don’t rely on this singular reading in a vacuum.