USD/JPY bracing for a rebound

February 10, 2014 — Mitul Kotecha

In the post below I look at the arguments for JPY weakness in the weeks and months ahead.

A combination of elevated risk aversion and a narrowing US / Japan yield differential have been the major contributors to the strengthening in the JPY over January resulting in safe haven JPY demand and repatriation flows. The sensitivity of the JPY to both factors has been especially strong and it will require a reversal of one if not both of these to spur another wave of JPY selling.

Improving risk appetite required
If there is not a metamorphosis of the current bout of pressure into a full blown crisis as seems likely, risk appetite will improve and the upward pressure on the JPY will abate. Any improvement in risk appetite will however, be gradual and prone to volatility, especially in an environment of Fed tapering. It may therefore require more than simply improving risk appetite to weaken the JPY anew.

Japanese equity performance will be eyed
Of course associated with any improvement in risk appetite has to be a reversal of the recent negative performance of Japanese equities. Although Japanese equities will continue to be hostage to the fortunes of global risk sentiment, assuming that “Abenomics” continues to deliver results and growth in Japan continues to pick up (our forecast this year is 2% YoY GDP growth) further fallout in the Japanese equity market may be limited.

Flows will need to reverse
Over the past several weeks Japan has registered net inflows of capital in large part due to repatriation by Japanese investors. JPY has faced upward pressure from such inflows over recent weeks. Looking ahead assuming that risk appetite improves and US yields increase net capital outflows are expected to resume, which will put further downward pressure on the JPY.

Yield differentials will be particularly important
The extra dose of JPY pressure and important determinant of renewed weakness will be a re-widening of the US / Japan real yield differential. Eventually US bond yields will resume their ascent, driving the yield differential with Japan wider, and putting upward pressure on USD/JPY. The same argument will apply for EUR/JPY, albeit to a lesser degree.

Speculation positioning more balanced
The recent short covering rally has likely resulted in a market more evenly balanced in terms of positioning, providing a solid footing for the next leg lower in JPY. Indeed, compared to the three month average, JPY positioning has bounced back and is susceptible to a rebuilding of JPY shorts over coming weeks, driving the JPY lower.

Model points to renewed JPY weakness
Combining the factors above (except positioning) and adding in forecasts for US bond yields, risk aversion and conservative estimates for a recovery in Japanese equity markets over coming months, my quantitative model for USD/JPY highlights the prospects of a major rebound in the currency pair.

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Calmer sentiment

June 14, 2013 — Mitul Kotecha

Gains in US stocks overnight will help to calm sentiment. The fact that US equities were able to shake off the 6%+ plunge in the Nikkei yesterday reveals the different perspectives in both markets. US markets were helped by a bigger than expected increase in headline US retail sales in May and a bigger than expected decline in weekly jobless claims.

A WSJ story that Fed Chairman Bernanke would highlight at next week’s Fed FOMC meeting that a “considerable” amount of time would pass before ending QE and raising rates also likely contributed to firmer sentiment while pressurizing Treasury yields lower. Commodities’ markets also showed some sign of stabilization.

The data slate today consists of mostly US releases including May industrial production and June Michigan confidence both of which are likely to record positive outcomes. Markets are likely to digest the data well and after recent bouts of volatility a period of calm ahead of next week’s FOMC meeting will be welcome.

The USD index has suffered a dramatic reversal of fortunes since reaching a high just under 84.5 on 23 May dropping by around 4.3%. Its tumble has taken place despite higher US bond yields and risk aversion, both of which would usually be expected to boost the currency. Fed tapering nervousness has done nothing to support the USD despite prospects of reduced asset purchases.

The USD’s move should not be seen in isolation, however. In the wake of major position adjustments across many asset classes usually strong correlations have broken down. Given recent record long USD positioning over recent weeks the pull back in the USD versus major currencies may have further to run but we suspect that much of the decline has already taken place. Given that the USD appears to be more strongly correlated to equities at present it may find some support from the gain in US stocks overnight.

Assuming that the USD’s declines begin to slow and even reverse the EUR is unlikely to extend its gains much further. The overall backdrop for the EUR is not particularly positive, with growth data remaining weak, albeit less so than in previous months. Additionally there are renewed concerns about Greece due to protests over the shutdown of the state broadcaster highlighting the difficulty in implementing crucial deficit cutting measures.

Meanwhile, European Central Bank Board member Mersch once again highlighted the possibility of utilizing negative deposit rates, which ought to prove to be a negative influence on the EUR, while other members including President Draghi continue to defend the potential use of OMT. EUR/USD will run into strong resistance around 1.3434 and I expect the upside momentum to fade over coming sessions.

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