Forex Investment and Currency Trading

• Correlation between equity markets and USD/JPY (and EUR/JPY, NZD/JPY, GBP/JPY) has broken down completely which has led…
• To the leverage community covering their short USD vs. JPY positions which has pushed USD/JPY above 92.00 and may target 94.00 (very key resistance)
• The volatility skew is collapsing as well.  At one point last week, a 6 month, 25 delta JPY Call Option was 8 vols more expensive than a 25 delta JPY Put Option…that is now down to 4 vols.  A huge collapse…
• NO ONE THINKS WE ARE GOING TO 85 anymore…

What happened to the locals…

• We were seeing strong flows from the Japanese community that invests in US equity and debt markets [life insurance companies (debt), treasury investors, retail equity investors, etc…] hedging their international investments (i.e. buying JPY forward) as the interest rate differentials collapsed. 
• Given the drop in the equity markets and treasury prices, the flows from this community, to buy JPY, has subsided.  It hasn’t seen any flows that suggest an unwinding of their hedges but anyalysts estimate that their hedge ratios have increased given the asset value of their investments has dropped in US dollar terms.

What happens next…

• If the price action continues, we could see USD/JPY trend toward the key resistance at 94.00.  If 94.00 breaks, we open the door to 100.00. 
• It will be an overnight move; it should be more systematic but there is one significant risk that should be noted…
• If we see the Japanese community, which has been buyers of JPY to hedge their positions, stop those hedge programs given the penchant for additional JPY weakness (which increases their yield on their international investments), JPY could start to weaken materially…the next step would be outright unwinding of their hedges which, if happened, could push USD/JPY to 105 in a matter of days as the leverage community stop/loss trading will intensify and create one-sided demand.
• If you have been on the sideline, now may the time to at least start adding some protection…we will probably see 91 or 90 trade again but the risks have definitely tilted back towards JPY depreciation. 
• Zero Cost Collars are attractive.  For those who make the argument that I do not need participation down to the low 80s, which is a fair point, forwards are still a good hedge.
  In the past 6yrs, we have only traded below 100, 7.3% of the time… so no one will be questioned with locking up hedges on at least a portion of their exposure below 100, let alone below 95.