Being one of the most liquid currency pairs traded, it is not surprising there has been significant activity and movement in this pair following unprecedented monetary policy decisions from both respective Central Banks, albeit each at a polar opposite to the other.
The last quarter, Q2 2022, has seen tremendous rises in the USD/JPY pair, driven by FED interest rate hikes relative to the BoJ. Japan has controversially not followed any other major Central Bank, and maintained its negative interest rates at -0.1% since February 2016.
This stickiness of the Japanese interest rates has meant this currency pair traditionally moves in accordance with US Treasuries. But with new pressures on Japan and the Yen, this pair may be facing some different challenges.
This candlestick chart shows the uptrend in the USD/JPY pair since the start of 2022. The weighted moving average line (blue) roughly acts as a line of support during an uptrend and a line of resistance during a downtrend. As shown, it is starting to act as a resistance near the peak, which suggests the start of a downturn, supporting a short position on this currency pair. The candle pattern near the peak is known as a bearish falling three, with the long red candle, 3 green candles and final long red candle. This is typical of a bearish pattern, as the uptrends have stayed within the range of the first big down day, and is suggestive of further downturn.
Catalysts
We believe the USD/JPY is a sell, backed up by the following reasons:
US bond yields are correcting themselves
Commodity prices are past their high, especially oil
BoJ will need to respond to pressure on the Yen through monetary tightening
1. US bond yields correcting themselves
Expectations for inflation were overestimated in the US in general, after the recent CPI report which was released 10 June 2022. Yields had reached a high of 3.4733% on 14 June 2022, but has since fallen. The upturn to this high was due to inflationary pressures meaning the FED increased interest rates, and further hikes later in the year were priced in. However, following the less-than-expected inflation reported for May 2022, it appears current interest rate measures are taming inflation, and further hikes need not be as large as expected.
US Treasury yields are a proxy for consumer confidence, not only in the US, but due to the US$ being the primary reserve currency in the world. Higher yields in general signal lower consumer confidence and lower demand for bonds, since prices (higher) move inversely to yields. With inflation seemingly being more subdued than expected, some confidence is restored in the US Government and its debt, and so yields fell.
With lower yields, the USD will depreciate and so the currency pair USD/JPY will fall. In addition, since expectations were overestimated, it is likely the USD will depreciate further as the market corrects itself. This will be more clear following 13 July 2022, when the June CPI report is released for the US. If inflation is further curbed relative to expectations, we could see a further fall in the USD/JPY currency pair. This supports our sell mandate.
2. Commodity Prices are past their peak
Similar to yields flattening and dipping, we believe a similar trend is occurring for commodity prices, in particular oil. Commodity prices skyrocketed at the same time yields did, both driven by inflationary pressure and expectations. However, we believe the peak has hit, and they are levelling off and starting to decline now. Copper, cotton and natural gas are all in bear markets. Oil's price has fallen around 12% over June 2022.
This will reduce inflationary pressures, and so reduce the need for interest rate hikes from the FED. A bear market in itself is a way to reduce inflation, although it does carry recessionary risks with it. Despite this, what it means for the USD/JPY pair is downward trends. Japan is an oil-importing country, and with few natural resources, is also a large importer of commodities. Lower prices will therefore benefit Japan, strengthening its currency, and lowering the currency pair. This supports the decision to short USD/JPY.
3. Japan cannot keep low interest rates forever
While Japan has maintained its ultra-low, negative interest rates for several years, without running into huge inflation problems, we believe this does need to change, so that the economy can fair better in the new economic climate.
Japan's recent CPI report (for May 2022) indicated inflation of 2.5%, up from 0.8% YTD. It has faired well compared to many western counterparts, which are suffering high inflation. However, there is still an uptrend in Japanese inflation, which may increase further if interest rates are left unchanged further. More than this, there is pressure on the Yen now. It has depreciated significantly due to the loose monetary policy, as capital has flooded out of Japan. It is not attractive for capital, and so little FDI (foreign direct investment) has reduced the relative value of the Yen.
This is a severe problem for Japan. Even with negative interest rates, there is little investment and economic stimulation. The monetary policy has not been very effective, and has just depreciated the currency. We believe this will not be sustainable, and while the BoJ is adamant it is sticking to its current interest rate, some monetary tightening is needed to stimulate FDI, curb inflation and protect the Yen.
Anticipating this will happen in the near future, in line with other major Central Banks, a surprise interest rate hike will appreciate the Yen relative to the Dollar. The JPY will be bullish, meaning we are bearish on the USD/JPY pair. The best bet now is to short the pair.
Summary
There are risks to this position, undoubtedly. Inflation and commodity prices could bounce back and reach new highs, which would undermine the position, however it is likely this is a short-term concern. It is unsustainable for prices to remain this high, and so the long-term sell position it still a viable option.
Another risk would be the BoJ does not raise interest rates. In which case, the currency pair will rise even further. However, the extent of this is unknown, as there is likely to be downward pressure from the first 2 factors we mentioned, even if the third is not achieved. The currency pair may reach a level of resistance and fall, in which case the short position is still a good option, however there is a risk if the currency breaks through the level of resistance in which case it is likely to rally further. However, this will put extreme pressure on the Yen, and whether at that point the BoJ will change its agenda is still a mystery.
It seems for now, shorting this currency pair does have a lot of support from market sentiment and fundaments.