Fundamental Forecast for Japanese Yen: Neutral
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Yen crosses are looking increasingly expensive with risk trends (Nikkei) struggling and the BoJ backing away from QE upgrades
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USDJPY expected volatility has collapsed to levels not seen since November 15, 2012 – a contrarian reading
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Half of the most liquid yen crosses closed out this past week in the green. Though, that should provide long-term bulls little relief. So far in 2014, this once high-flying group is under water. The forces that provided the momentum of 2012 and 2013 – a reach for yield and the introduction of a massive stimulus program from the BoJ – have been sidelined. And now, fear is creeping in that there is a very real risk that speculative appetites are starting to wilt and the central bank is shelving plans to upgrade its QE plans. While neither theme is threatening to collapse – yet – the yen crosses may still topple (yen rally) in the absence of further expansion.
Some markets and themes default to a certain bias. The S&P 500 is a great example whereby it naturally rises in the absence of conflicting fundamental catalysts due to the chase for returns over the last five years. At one point, the yen crosses shared that innate momentum, appreciating off the back of speculative appetite – some see it inversely as a lack of fear – and the afterglow of the Bank of Japan’s (BoJ) sizable stimulus upgrade. Yet, both of these drivers are losing power and it is proving increasingly difficult to connect them to this carry trade. If indeed we are running out of hot air to keep this balloon up, the market will quickly recognize how high we are.
We are currently between 40 and 15 percent above the levels the yen crosses were lurking before the market began its run up in anticipation of the open-ended stimulus program. That is a hefty premium, particularly when we look for a fundamental valuation familiar to these pairs – carry. Whether we use benchmark rates, government bond yields or further-from-prime market returns; we find the ‘carry’ on crosses are still historically low. The deviation between this underlying worth and current market rates is extreme, and an ominous liability. This is especially true when we note the long-standing congestion in pairs like USDJPY or that implied (expected) volatility for the same pair over the coming month has dropped to its lowest level since November 2012. These are potentially explosive conditions of complacency.