When I was first learning to spell “FX” – it was some years ago – the bank that somehow saw fit to hire me had a formal training program for new recruits in sales and trading. In the segment on currencies, we were taught that three major factors determine exchange rates: the balance of payments, interest rate differentials, and politics. A lot of research has been done since then, and the consensus now is that the market reacts rapidly to economic indicators that suggest looming changes in the balance of payments. Similarly, market expectations as to future rate differentials, rather than current conditions, are watched for clues as to currency movements. “Skate to where the puck is going to be, not where it’s been”, as The Great Gretzky used to say. The catch-all “politics” still matters.
I bring this up because the Japanese Yen has had a 3.36% downward move against the U.S. Dollar since Monday (that is, USD/JPY is 3+% higher). In this case, the major factor driving the pop was a change in the market’s assessment of future interest rates. The Bank of Japan BOJ), which like the Japanese government is under new management, overnight unveiled an unexpectedly aggressive program of bond buying and other measures designed to break the deflationary cycle that has been in place for many years, and generate 2% inflation. Inflation is a negative for currencies, as it reduces the real return of investors in bonds denominated in that currency, and the Yen has responded by weakening significantly. Besides, Prime Minister Abe has made it very clear that he regards a weaker Yen as essential to restoring Japan’s export competitiveness (a weaker currency makes a nation’s exports cheaper for those whose currencies are strengthening). The move has been encouraged by the proximity of North Korea, and its nukes, to Japan (politics, again).
What does this mean for those of us who just want to make some money in currencies? Studies since I was a trainee indicate that while central banks can have real difficulty in moving their currency higher (“revaluing”), they generally have the tools required to make them weaker (“devalue”). The Bank of Japan is now banging drums and doing whatever else is can think of to get people to sell Yen. The bond buying program outlined last night, as a percentage of GDP, is considerably more aggressive than the Fed’s quantitative easing. Again, in my experience, it makes little sense to argue with a central bank when it’s in the sort of mood the BOJ is in now; much easier to go with it, and (optimistically) make some relatively easy money.
In the case of USD/JPY, the recent high was 96.70 back on March 12, so the overnight pop, while impressive, hasn’t even challenged the previous top. One of the peculiarities of the Japanese currency market is a relatively free flow Â of information among local players regarding buying and selling interest. Friends who are far more plugged into that market than I am report a good deal of desire to buy USD around the 94.80/85 area by those who aren’t yet as long of USD as they wish they were, at least retrospectively. A corollary is that Japan has competitors in many export sectors throughout Asia. As the Yen weakens, the central banks of South Korea, et al, may well respond by moving to push down their own currencies so as not to be disadvantaged by Japan’s maneuvers. They normally do this by selling their own currencies for Dollars. Overall, that tends to make the Dollar stronger, and since the Dollars purchased are typically invested in U.S. Treasuries, it tends to keep bond prices higher/yields lower than would otherwise be the case.
As Dr. Reid noted in another of his excellent pieces yesterday evening, working out how to trade moves retroactively is pretty easy; the difficult part is deciphering what the right hand side of the chart is going to do. There aren’t any guarantees that USD/JPY is going to go higher, but the map of past demand and supply, aka “the chart” looks quite positive, and institutional traders will take a lot of comfort from the lesson that it only occasionally makes sense to fight against a central bank that is trying to force its own currency lower.
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