Having enjoyed a largely one-directional ascent since the end of March, when it was trading around 105, and rising above 114 in early October helping push the Nikkei225 to 27 year highs...
... the weakness in Japanese yen, traditionally a safe haven during risk-off times, has finally cracked and starting around the time of Thursday's selloff has jumped with the USDJPY sliding over 100 pips today as traders demand haven protection amid fears about China’s depreciating currency and the U.S.-China trade dispute, dropping below 113 to 112.85 - the lowest level since late September.
As Bloomberg notes, the yen is stronger against all its G-10 peers Monday as traders demand haven protection amid fears about China’s depreciating currency and the U.S.-China trade dispute. The yen strengthened after U.S. Secretary of State Michael Pompeo cited “fundamental disagreement” with China’s foreign minister during a testy exchange in Beijing that highlighted rising tensions between the world’s two largest economies.
And now that the upward momentum appears broken, USDJPY may have much more to drop.
In a prescient note published last Thursday, Deutsche Bank's FX strategist George Saravelos wrote that it is time to sell the USDJPY, for three specifics reasons:
(1) The correlation between US yields and equities will likely turn negative. USD/JPY has benefitted from the “perfect mix” of rising US rates and equities. But the DB fixed income colleagues make a compelling argument that at a level of US yields around 3.50% it becomes far tougher for equities to rise in tandem with yields.
In turn, this should be negative for USD/JPY because it is equity outflows that have dominated Japanese investment over the last twelve months. Weaker equities via slowing outflows and repatriation will matter more for the yen than rising rates. In this world, yields higher, USDJPY lower hybrid trades offer substantial correlation cheapening.
(2) Japan to sell USD/JPY above 115. According to DB, it has received strong feedback from pension fund and lifer investors that they see little value in holding unhedged dollar investments above 115. This sentiment can be seen in the record levels of USD/JPY selling already taking place by local margin speculators, i.e. Mrs Watanabe's momentum chasing is at a record.
Historically such extreme levels of USDJPY positioning from Mrs Watanabe have either coincided with a top (October 2017) or a stop-out move higher (May 2015) which then reverses as the longer-term investors step in. Either way, this extreme level of local yen bullishness is reflective of the local view of the yen and fits in with Deutsche's assessment that the yen is the world’s cheapest currency.
(3) BoJ stealth tapering is alive and well. The BoJ signaled a clear desire for greater volatility in the JGB market in its July monetary policy meeting reflected in the continued subdued buying of JGBs even as yields rise.
While the new 20bps ceiling to 10-yr JGBs is unlikely to be breached the same cannot be said of longer-dated yields which are now making new cycle highs as the Japanese curve steepens. BoJ tolerance for steeper and higher yields limits policy divergence with the US and the return of fixed income outflows. It is also coinciding with renewed upside surprises in Japanese inflation amid Japan’s exceptionally tight labor market.
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In making its reco, DB concedes that it may be a little early on the trade "given the stop-out risks of extended local margin positioning, positive equity seasonals around US midterms and the fact that we are only just starting to cross the threshold where rates matter for equities." However, in light of the extreme level of yen valuations, the bank "prefers being early rather than late in buying the yen - the upside is far greater than the downside."
So far, its trade has been spot on, and once the CTAs get on board and start pushing momentum lower in the pair, the yen may soon be revisiting the 2018 highs, especially if the BOJ gets cold feet about "renormalization" after a few more days of sharp selling in stocks.