Over the past 6 weeks, USD/JPY has had a tremendous run. On Feb 1, it was trading at 76 and today, it rose above 83.50. This 7.5 yen move impressed everyone, particularly given the lack of meaningful correction. But the burning question in everyone’s minds is how much further can USD/JPY rise. A few weeks ago, I pointed to the break of the weekly cloud cover as the main technical reason for my pro USD/JPY call. Since then, the pair has rise a mere 250 pips. This is peanuts compared to how much USD/JPY has run on past cloud breaks. From the top of the cloud to the top of the initial rally (not counting the pullback and continuation), USD/JPY rose 29 Yen (97 to 126) in 1995, 18 Yen in 2000 (108.5 to 126.85) and 12 Yen in 2005 (108.5 to 121). From a levels perspective, there will be resistance at the 2011 high of 85.50. In fact, we could even see a bit of consolidation around that level. But even if we low ball the potential move based on how weekly cloud breaks have performed in the past and then downgrade it some more, USD/JPY could easily reach 90.
The best part is that there is fundamental support for the rally. Unlike the Federal Reserve who has frozen monetary policy, Japan is on a rampage to keep the Yen weak through easy monetary policy. The massive current account deficit reported last week also changes the inherent dynamics in the Yen. Although this is expected to be temporary, for the time being Japan is no longer a surplus country. At the same time, rising U.S. yields is sending the dollar sharply higher. The only potential cause for a pullback in USD/JPY would be repatriation ahead of the March 31st fiscal year end.
1995 break – 29 Yen in 21 months
2000 break – 18 Yen in 5 months
2005 break – 12 Yen in 5 months
2012 break – 7.5 Yen in 1 month
Last week, I was all over the weekly cloud cover break in USD/JPY (see chart one), talking about how important it is and why further gains are likely. It is a new month now and we have another important technical break on the monthly chart (see chart 2). USD/JPY closed above its 20-month SMA. This confirms the degree of bullish sentiment in the market right now and reinforces my view that USD/JPY is headed higher for 85.
Over the past 18 years, USD/JPY has CLOSED above its weekly cloud only 4 times (not counting this one) and in 3 out of those 4 instances, a very sharp rally in USD/JPY followed.
1995 break – USD/JPY rose from 97 to a record high above 146
2000 break – USD/JPY rose from 108.50 to a high above 134
2005 break – USD/JPY rose from 108.50 to a high of 124
2009 break – FALSE BREAK
2012 break – ????
USD/JPY has been on a tear since the beginning of the month in large part due to rising U.S. yields. Based on the following chart, the slope of the recent rally in USD/JPY is much steeper than the slope of the 2 year U.S. Treasury yield which suggests that either the run in USD/JPY is overdone or U.S. yields need to rise further – you decide.
JPMorgan is trying to compare this to Dec 2009, which I have circled in the chart:
There have only been two instances since the Fed started its zero interest rate policy, when the USD was strong at the cost of the JPY – February 2009 and December 2009. Particularly, the latter month saw a risk rally, which is a better resemblance of the current situation. USD/JPY rallied about 10.5% in December 2009. If we see a rally of the same magnitude this time around, the pair could reach 84. That being said, we still believe USD (and hence USD/JPY) upside is limited unless we see a sharp rise in UST yields
The first two trading days of 2011 has been very kind to USD/JPY. After falling for 2 weeks straight, USD/JPY has finally found a bottom. According to my 2011 Dollar outlook, improvements in U.S. data should help the dollar recover in the beginning of the year. So far, we have seen some nice upside surprises and Friday’s non-farm payrolls report is expected to be very strong. I do not believe that the dollar will be in a long term uptrend this year, but I do believe that the first few months will be kind to the beleaguered currency.
I can’t take credit for this chart – my buddy at Nomura sent over this chart of USD/JPY in relation to US yields. The white line is the USD/JPY spot rate, the yellow line is the 5 year US-JPN yield spread and the orange line is the 2 year US-JPN yield spread. As you can see, there is a strong relationship between these instruments and the lines do not usually diverge significantly. However that changed in December, when USD/JPY fell steeply DESPITE a rise in the yield spread. What this chart suggests that USD/JPY ought to be trading at 86 and not 82.
USDJPY is down on the day and it shouldn’t be surprising for those of you that have been watching yields. Since the beginning of the year, the USDJPY has had a 90 percent positive correlation with 10 year yields. Today, yields are down and accordingly, so is USDJPY. The big debate in the market is whether yields are rising because of the brighter economic outlook for the U.S. economy or the lack of demand for U.S. Treasuries after Obama announced the cost of his tax plan. It is never so black and white my friends – always a combination of both.