Forex Investment and Currency Trading

• USD-JPY put in a major double bottom in the 87.12-15 area
• Short-term technicals remain bullish for 98.00 initially, then 101.26
• JPY gained from repatriation and de-leveraging, but most of this appears done
• Japanese fundamentals are dire and continuing to get worse
• Japan is now recording trade deficits, Japanese investors are looking abroad again

USD-JPY put in a double bottom in the 87.12-15 area and reversed higher. Short-term technicals remain bullish, arguing for further near-term gains to 98.00 and potentially 101.26. Note that this is happening at a time when equity markets remain volatile – although the VIX index of S&P 500 implied volatility has been setting gradually lower highs. Japanese economic fundamentals are truly dire and continuing to worsen. Until recently, that did not seem to matter because the Japanese yen (JPY) was being supported by repatriation and de-leveraging. However, the latest data of foreign participation in Japanese call money market borrowing strongly suggests that most of this de-leveraging has already been done. Moreover, weekly investment data shows that Japanese investors are starting to look at investing abroad once more. Finally, Japanese trade data is now showing successive trade deficits. Given this fundamental and technical backdrop, USD-JPY may have further upside near term.

Two upside option structures for USD-JPY, measuring the cost of these against a 3M 95.00 vanilla USD call/JPY put, anticipating further short-term upside in USD-JPY:

Trade idea: 3M USD-JPY upside structures
(The following are indications. For actual prices, check with your FX brokers)

• Spot reference: 95.15 3M 105.00 one touch 20/25% of payout
• Spot reference: 95.15 3M 95.00 USD call/JPY with 110 RKO Cost: USD 2.35%/2.75%
• Spot reference: 95.15 3M 95.00 USD call/JPY vanilla Cost: USD 3.75%

Fundamentals

The view is that most JPY gains, which were due to de-leveraging, repatriation and global risk aversion, have already been seen. The percentage of Japanese call money market borrowing by foreigners – a reflection of the “carry” trade – is now back to much more modest levels. Moreover, Japan’s trade balance is now in deficit and Japanese investors are starting to invest abroad once more. To be sure, the JPY may see further modest gains near term, but this is already priced into forwards. The JPY was one of the star performers in 2008, rallying by 22.87% against the USD, 27.83% against the euro (EUR), 14.79% against the Chinese yuan (CNY) and a stunning 65.99% against the South Korean won (KRW). Heading into this explosive rally, the JPY was massively undervalued. Japan’s current account surplus was surging. The combination of this external surplus and slowing outflows eventually triggered a major capitulation of JPY shorts, causing the currency to rally across the board. However, historically, the JPY requires momentum to sustain a rally given the fact that Japanese interest rates remain so low – and it appears to have lost that momentum. Year to date through 16 February, the JPY has actually lost -2.48% in value against the USD, despite gaining a further 8.43% against the EUR. Near term, the JPY continues to gain ground against the rest of Asia, notably the CNY and KRW. However, here too, upside momentum appears to be fading.

The JPY’s valuation remains in question as REER and PPP appear to be giving diverging signals. However, what is not in question is that the previous massive undervaluation of the JPY has been significantly unwound. The fact that Japan’s trade balance is now recording deficits hints that this JPY rally may have already gone too far. Particularly noteworthy is the fact that Japan’s trade surplus with the rest of Asia is also collapsing. At least part of this has to be due to the competitive hit from JPY appreciation. On the capital account side, Japanese repatriation ahead of fiscal year end on 31 March typically peaks at the end of February. Moreover, Japanese institutional investors appear to be looking to increase foreign allocations once more, particularly in emerging markets (EM) given much better valuations and the rally in the JPY.