Category — Japanese Yen

Financial markets look to be rebounding after their huge drops in the last couple of weeks. Markets have seen an uptick in value and, and recent news only seems to support that trend. The primary effects of this movement on the foreign exchange market have been twofold: providing the Fed with justification to slow down the easing process and giving Mrs. Watananbe the ability to resume the carry trade.

Let’s look first at how the financial markets have returned to a relative state of calm. The four biggest US banks borrowed $500 million each from the Fed’s discount window yesterday. None of the four actually need the money, but the act is a symbol of trust in and acceptance of the Fed’s recent decision to lower the discount rate. Bank of America also took a new $2 billion stake in Countrywide Financial, the nation’s biggest lender of home loans, a catalyst that drove down corporate bond risk and drove up stocks. Once thought to be on the verge of bankruptcy, Countrywide appears to have survived the crisis, signaling hope for the larger economy. Looking at the broader equities market, the VIX index feel even more yesterday, now sitting more than 40% lower than the highs hit last week.

All this good news might indicate that the Fed doesn’t have to ease rates to the extent that futures traders have priced in. And indications from US central bankers point to the Fed not really wanting to lower rates just now (the moral hazard problem). The Fed has a number of different options as to what it could do in September and October, but it has to realize that the credit problems are still far from over. Commercial paper is still being ignored to a ridiculous degree, and if a wide scale easing program is not implemented, then we could see the problems of Wall Street spread to Main Street.

A spread to the wider economy is not out of the realm of possibility. Layoffs in mortgage companies are coming, and the big banks are already shutting down their subprime units. More troubling is what happens to mortgage rates if the Fed keeps rates steady. Adjustable rate mortgages are set to be re-priced next month, and with credit conditions as they are now, we will see consumers swamped with enormous debt service bills. Consumers are the engine of the US economy, and any slowdown in that sector because of higher bills could be disastrous. That said, if the Fed keeps rates steady, it would also be bullish for the US dollar in the short-term. As corporate profits shrink and equities markets decline, we would see a strengthening of the dollar’s safe-have bid, and USD/JPY, especially, would see the bottom fall out.

But with the stock market reasonably strong and most market participants sure of a Fed funds interest rate cut, the US dollar is seeing some capital outflow and so is the Japanese yen. The dollar-yen hit 117 last night, and the carry trade seems to be returning. Mrs. Watanabe saw in the recent drops the same buying opportunity that hedge funds proclaimed (and quantitative funds have made back most of their losses this week). We should see at least two rate cuts this year in the United States and that should generally prove bullish for the carry trade. But as always, be careful.

The yen crosses are all taking a beating. After more than a year of weakness (mostly through carry trade borrowing) the Japanese yen is cleaning up. Even the US dollar, up against all the other major currencies, is not safe from the yen’s resurgence.

The yen is now at its highest level since July 2006. The high-yielding currencies have suffered the most, with NZD/JPY and AUD/JPY both falling over 5% yesterday. EUR/JPY has acted the proxy for carry trade sentiment in the foreign exchange market, and the currency pair fell 2.3%. And just as we predicted yesterday, USD/JPY blew past the stops at 116.50, and reached 113.60 in early New York trading. Even against the pound, which looks to be the most fundamentally-backed of the major currencies has fallen against the yen, as GBP/JPY dropped 700 pips yesterday. The carry trade unwind is on, folks, and this is just the beginning. If the market has its way, the Japanese yen will appreciate even more.

But that’s just the thing. There’s a chance the foreign exchange market will not be allowed to have its way. The Bank of Japan has a well-deserved reputation for aggressive intervention, and it will be looking at the recent yen gains with some dismay. Japan’s domestic economy basically sucks, and the country’s production is being kept afloat by its world-beating export industry. A stronger yen is bad for business. That’s the reason that Toyota’s share price fell 3% last night. The BoJ could look at the yen crosses and say the Japanese currency is overbought. If that happens, we will see the yen give back a lot of its gains.

“Mrs. Watanabe” is the designation used to describe the typical Japanese woman, and she is killing the professional forex market right now.  Currency analysts at places like Deutsche Bank and Goldman Sachs predicted USD/JPY to end this year around 115, or even lower.  But until the catastrophic events of this past week or so, the yen has not been able to do much better 120/dollar.  And much of the reason for that is Mrs. Watanabe.

Fundamentally, the yen should be rebounding.  The Japanese economy is starting to emerge from its decade-long slump, and the currency should rise with it.  But the overnight lending rate in Japan is still only 0.5%, making the currency an attractive borrowing option for the carry trade.  And retail investors are (or at least have been, before this week) in love with the carry trade.

The Japanese retail forex market is especially important because it is bigger than the retail markets in the rest of the world combined.  You can even get savings accounts in Japan denominated in something other than yen.  And in Japan, the investment decisions of the household are made by the wives.  Those wives are as enamored with the carry trade as anyone else.

In July, Bank of Japan board member Kiyohiko Nishimura made a speech praising these Japanese housewives for steadying the forex market.  Historically, the carry trade has always ended disastrously (although it has always rebounded from that crash) with investors across the board rushing to get out of the trade all at once.  Mrs. Watanabe does not act that way, however.  Every dip in USD/JPY is a buying opportunity, and as such, she reduces currency swings.  It looks like the carry trade is near its end.  But it was a good ride while it lasted, thanks to Mrs. Watanabe.  A gnome of Zurich, she is not.

Traders and investors in financial markets around the world are preoccupied with paring back their risk exposure.  Internationally, emerging market investments are being cut back.  In the US equities market, stocks are losing attractiveness in favor of safer Treasury bonds.  With regard to the foreign exchange market, traders are shunning the risky carry trade.  The ultimate consequences of all this activity are strong support for the US dollar and the Japanese yen and a decline in the other major currencies.

The greenback’s rise is interesting.  With America at the locus of the subprime crisis, its currency is also the greatest beneficiary.  When risk rules the market, traders park their money in dollars, and that is likely to continue for some time.  EUR/USD acts as a proxy in the FX market for dollar sentiment, and the euro is on track to take a beating.  Economic data from the continent has also disappointed, while US Retail Sales surprised to the upside.  Unless the Fed surprises everyone with an immediate interest rate cut, dollar bulls should continue to smile.

The Japanese yen has been the other recipient of good fortune during this subprime mess.  All of the high yielders have taken turns falling against the yen.  Technical analysis points to now being the turning point for GBP/JPY.  But while the carry trade unwind is driving this growth in the yen, economic data in Japan is not supporting the rebound.  And so a long-term outlook in the currency cannot be positive.  The Bank of Japan does not have a basis to raise interest rates, and the yen will suffer accordingly.

Central banks are the major players in the FX market in this current environment.  Will the increased liquidity ease credit concerns?  Many analysts predict that the banks will be forced to concede inflation and lower rates to stave off a world-wide recession.  But predictions of this hard landing are wrong.  The market correction should even itself out, and the increase of money in the market should keep buying and selling going.

The carry trade is not back. At all. Stay away for right now. The Dow rallied to close 150 points higher yesterday, and yen crosses followed that stock market rally. The high-yielding currencies, especially, made back a lot of their losses. But the upward movement is likely to be temporary because the current market is not conducive to the carry trade.

Volatility is still significant (the stock market may have ended in positive territory, but it wavered back and forth throughout the day). Risk aversion in the market is at a high level. This is the reason that US Treasuries continue to do well; the bonds gained 1.6% last month, second-best performance of all major international government bonds. And then there are the comments yesterday out of China threatening to dump dollars in response to protectionist legislation in the United States. No rational observer of the market actually thinks this is a likely possibility, but the chance is there. If nothing else, the proclamation by the government researcher reminded investors (in the forex market and elsewhere) of the potential power that China holds to disrupt international financial markets. And the fact remains that we do not have a long-term record to rely on of responsible financial administration out of China. The more people are afraid of risk, the worse the carry trade does.

The carry trade is a complicated proposition for anyone participating in the FX market. That’s why so many people get it wrong all the time, including those who make their living trading the currency. There’s so much information bouncing around the market, and traders are relying on fundamentals and technical analysis and have trouble deciding when different signals suggest different actions. As sacrilegious as it might sound, traders might actually be relying on too much information.

The great thing about the internet is it brings real-time news about everything right to our fingertips. But too many choices (for a trader) can actually be a bad thing. There’s a book out right now called The Paradox of Choice, and it’s about how, at a certain point, more options actually reduce the amount of choices available for an individual. We are paralyzed by the sheer number of things that we look at, and so we are unable to focus (or choose) the most valuable information. Bringing it back to the carry trade, the important observation to keep in mind is the following: carry trade thrive on three market conditions: (1) low volatility in international financial markets, (2) cheap money (or credit) and (3) a strong risk appetite among investors. The carry trade will not rebound because none of those three conditions are met in the current market climate.

The FX trading last night is evidence of this point. EUR/JPY, which has acted as a proxy for carry trade popularity, lost 200 points. The Swiss franc gained support through both a run away from the carry trade and a run toward safe havens. The high yielding currencies will continue to lose ground as both phenomena continue. USD/JPY will be the one of the few yen crosses to buck the trend because of the US dollar’s status as a store of value and a safe haven. But that is an abnormality and should not fool traders into thinking the carry trade is back.

After modest gains this week, the U.S. dollar fell against the yen and euro on news of poor U.S. jobs growth. A government report today showed 92,000 jobs added for July, falling well below expectations as 126,000 jobs were added in June. Economists at Bloomberg predicted 127,000 new jobs for the past month. In addition, the unemployment rate rose unexpectedly to 4.6 percent up from 4.5. These are signs the U.S. economy is still hurting from the subprime crisis as investors are losing this week’s earlier appetite for risk. The dollar fell to $1.3727 against the euro this morning in New York, down from $1.3703 yesterday. The increase in risk aversion has also caused the dollar to fall against the yen from 119.21 yesterday to 118.93 this morning.

Poor U.S. job growth and resulting increase in unemployment may prompt the U.S. Federal Reserve to lower interest rates this year to reboot growth. This may be a sharp change in monetary policy as rates have been kept strictly at 5.25 percent for 2007. Mathew Strauss, a senior currency strategist at RBC Capital Markets Inc. in Toronto, comments: “The payroll number raised concern that the slowdown in housing may start to affect growth. It seems one supporting factor for U.S. consumers may start to lose ground—a strong labor market.” Investors betting on futures contracts on the fed fund rate due in December changed forecasts on the yield to 5.02 percent, down from 5.21 percent from a month ago. The Fed will next meet on August 7^th.

Currency Outlook and Forecast:
The decisive factor for the future U.S. dollar movement is the subprime crisis. The big question bothering investors is whether the U.S. housing slump will spill over into the rest of the U.S. economy. Speaking on this issue, Jim Rogers, co-founder along with George Soros of the Quantum Fund, believes losses from the subprime-market have a long way to go. According to Rogers: “This [subprime defaults] was one of the biggest bubbles we’ve ever had in credit.” He forecasts U.S. investment banks and homebuilders will take further hits. Bear Stearns stock fell 13 percent last week. Shares in other investment banks such as Merrill Lynch and Lehman Brothers also fell this week.

Kathy Lien, chief currency strategist at FXCM, forecasts August to be a tough month for the U.S. dollar. She believes tighter credit and the housing blowup will have significant negative effects on the U.S. economy this month (see her article at dailyfx.com). Don’t expect steady long term gains in the dollar anytime soon, especially as the Fed may be lowering the borrowing rate later this year.

We’ve been talking about the carry trade unwind for the past couple of days.  The moves in the forex market yesterday and during Asian trading last night ran counter to that assumption.  There was a reversal upwards in the yen crosses, especially CADJPY, AUDJPY and NZDJPY.  The late rebound in the Dow also buoyed USDJPY, as that currency pair has assiduously followed the ups and downs in the equities markets for some time now.  But I am here to tell you that the prognosis with regards to the currencies in the United States and Japan is still yen-positive and dollar-negative.

Let’s starts with the bad news for the US dollar.  The bond market is pricing in a 100% chance of an interest rate cut in January.  DailyFX.com has a fascinating take on the interest rate speculation through a look at the comments of various US monetary policy makers, with the ultimate scenario suggesting a more dovish outlook for the Fed.  The ADP survey shows terrible job growth numbers, coming in at only 75K.  Earnings for most US corporations continue to be relatively stellar, but the money refuses to trickle down, and dollar bulls may have to come to terms with a slowdown in US expansion.

Coming to the yen, most currency analysts see still more room for the room to grow.  The Chicago Board Options Exchanges’ market volatility index (VIX) hit a yearly high yesterday, and greater volatility is a death knell for the carry trade.  Kathy Lien of FXCM posts a two-year chart of USDJPY that will not provide comfort for yen bears.  The interesting thing about the chart is not that it necessarily signals a move downward in the currency pair but that it demonstrates the potential of a possible drop.  And that drop would be disastrous for those still long on the carry trade.

For some months now, dips in the yen crosses have not really been something to worry about; rather, these dips have been seen by Japanese retail investors as opportunities to short the yen.  There has been talk all over the market about “Japanese housewives” beating the pros and serving to stabilize the market by keeping carry trades alive.  But a recent Bloomberg report claims that the risk appetite for Japanese traders is dropping.  They are wary of selling the yen now because they anticipate still more appreciation for the currency, which has the potential to be a self-fulfilling prophecy.  And contributing to the growth of the Japanese yen are the losses all over the hedge fund market in the United States.  The hedge funds were some of the primary drivers of the carry trade, and their exits from the forex market (at least in this limited capacity) might serve notice to the rest of the market that the carry trade is, indeed, unwinding.

A worldwide credit crunch and economic problems (mainly in the United States) have torched the equities markets for the past two weeks.  There are fears that the subprime mortgage crisis and the housing problems will escape their respective sectors and infect the market as a whole.  The losses are magnified by the uncertainty of many traders, exemplified by the VIX volatility index surging past previous levels.  As is usually the case in a situation like this, risk aversion is controlling the market.  With regard to foreign exchange trading, two phenomena emerge: a flight to safety for capital and a carry trade unwind.  As Boris Schlossberg of DailyFX.com notes, the only winners in this scenario are the US dollar and the Japanese yen.

Flight to safety in the forex markets is beneficial to the US dollar, at least temporarily.  This is because investors pare back from riskier investments and park their capital in dollars for the time being.  The result is a peculiar situation where the crumbling of US markets is actually a boon for the US dollar.  But traders should realize the dollar strength will not last.  As for the US stock market, there is a sense that the credit crisis is reaching other areas; there are reports in Bloomberg that situation with subprime mortgages are hurting the earnings of companies across the spectrum.

And the economic reports have been mixed.  The regional manufacturing surveys (Philly Fed and Chicago PMI) have disappointed, confounding observers who thought the weak dollar would allow exports to support the manufacturing sector.  But unemployment is in line to grow by 100K for the NFP report later this week.  How traders react to that data will determine the long-term direction of both the US economy and the US dollar, but on a short-term basis, the dollar looks good.

Growing risk aversion also creates problems for carry trade longs.  Yen bulls have killed the fx market for the last two weeks.  There has been a 1000 pip decline in GBPJPY (from its record high), and the yen has also gained 700 points against the three commodity currencies.  In fact, the yen improved against all 16 most highly traded currencies last night.  Carry trade lovers cannot start crying over their losses yet, however; Kathy Lien of FXCM claims there is still plenty of room for the yen to appreciate.  Fear is the dominant factor ruling the currency market right now, signaling a strong near-term weakness in the Australian dollar and the New Zealand dollar, two currencies that have gone up significantly on the back of the yen-based carry trade.  I am not one who believes that the credit crunch puts us in line for a global slowdown (and the great thing about trading currency is that it doesn’t matter—there is the same opportunity for profit in a bear market as there is in a bull market).  But I think traders should be wary of high risk investments and focus instead on more stable currencies and economies.

Global equities markets took a beating last week. The phenomenon began in the United States (on the back of subprime mortgage concerns) and it spread to the financial markets in other countries. For the forex market, the primary impact of the losses was a return of risk-aversion. The risk appetite of currency traders has waned, and as a result, the yen-based carry trade has begun to unwind. The US dollar has also appreciated significantly as investors run to the safety of US assets. But the search for yield and the changing fundamentals of the market complicate matters, and the current trends may not last.

Regarding the carry trade, it is risk aversion driving the FX market. Japanese fundamentals stink, with Retail Sales disappointing to the negative and deflation sill a concern. But the yen continues to gain as greater market volatility hurts the carry trade. But this is all dependent on the equities market. If the Dow recoups its losses this week, we will see a renewal of the yen carry trade.

The US dollar also saw some improbable gains this past weekend. With investors more conscious of risk, the stability offered by dollar-denominated assets is more appealing. Americans, concerned about losing their gains overseas, repatriate their holdings into US dollars. For international traders, the US dollar becomes a store of value, just like holding gold or silver. Emerging markets in Asia were especially hard hit as overseas investor sunned riskier assets in favor of American ones. This particular phenomenon is controlling the currency market, overpowering economic factors that would pull back the US dollar (like the disastrous Existing Home Sales report).

But the forex market changes very quickly, and if last week’s equities market decline proves temporary, then we could see both a resumption in the carry trade and a plunge in the US dollar. The yen already began giving back some of its gains in European and Asian trading this morning with EURJPY, GBPJPY, AUDJPY and NZDJPY all riding upwards. And the US dollar cannot maintain its status as a store of value forever.

The latter situation is pretty interesting. The dollar benefits from its use as the currency of choice in international trade and as the primary denomination in foreign reserves. We have talked in the past about how other countries are starting to move away from the US dollar both in terms of international trade and in terms of foreign reserves. And there are reports in Bloomberg today of increasing protectionism with regard to foreign ownership of assets in the United States and Europe. This hurts the dollar and the euro because it makes dollar- and euro-denominated assets less attractive. And US fundamentals do not look like they are going to get better anytime soon. A recent Fed report suggests that even the weak US dollar may not help the trade deficit. We may see temporary gains in the greenback and the yen, but a long-term outlook does not bode well for either currency.

Yesterday’s report on the extremely sluggish U.S. housing market sent equities markets crashing, investors dumping corporate debt, and currency traders unwinding carry trades. New U.S. homes sales for June fell 6.6 percent. This number has jumped significantly from the 2.2 percent decrease in May. According to a Bloomberg article, this may be a no end to the real-estate slump. The housing issue has even breached the international level as a report today by the U.K.’s Nationwide Building Society showed home values to have risen only 0.1 percent in June, the slowest in 15 months.

The faltering confidence in the equities markets has also brought shifts in forex. Despite having been on a six-week run against the dollar, the pound took its biggest fall in the last five months. The pound dropped 1.0 percent in one day to $2.0305 at 1:04 p.m. in London from $2.0491 late yesterday. On July 24^th the pound had reached $2.0654, its highest level since May 1981. The pound and the euro also took major hits against the yen, indicating investors are losing confidence in their carry trades with the Japanese currency. Against the yen, the pound fell to 241.27 from yesterday’s close of 243.21. Steven Barrow, chief currency strategist at Bear Stearns Intl. Ltd. in London, states: “There’s a reasonable degree of panic going on with the whole mortgage and credit issue and that has encouraged risk aversion.”

Currency Outlook and Strategy:

The sharp fall in the pound has allowed the 14-day RSI for the GBP/USD to fall below 70. This indicates that a reversal will not come anytime soon. Kathy Lien, chief currency strategist at FXCM expects “room for more losses” in the pound. In addition, traders have taken steps to hedge against the risk of a rallying yen. The cost of options protecting against gains in the yen rose to a 3 year high. This movement of risk aversion indicates a revival in the carry trade may not happen anytime soon. Neil Jones, head of European hedge fund sales at Mizuho Financial Group Inc. in London, states: “Investors are looking for some short-term protection on their exposure to the yen strengthening.”

History has shown us an interesting pattern where the EUR/JPY pair has followed a very similar trend to that of the U.S. Dow Jones Industrial. As the Dow takes hits so does the EUR/JPY. See more on this pattern in an article by FXCM technical currency strategist Jamie Saettele. Overall, the leveraged-buyout financing era has taken a huge fall. There is much uncertainty as investors are shifting their portfolios toward less risky assets. Steve Pearson, chief currency strategist at HBOS Treasury Service PLC in London, reflects: “[The] three year period where financial market volatility has declined to low levels is over.” For now it is best to let the markets react and then change strategy.