The Hated Currency Trade: Buy Japanese yen
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The Hated Currency Trade: Buy Japanese yen

Posted by Jack Crooks

on Tuesday, 16 January 2018 17:40

If extreme sentiment can be used as a contrarian indicator, and it has stood the test of time in many different markets, then now might be the time to load up on Japanese yen—it seems hated, and yet it is starting to appreciate. 

The Japanese yen, quoted in the forex market, is USD/JPY; i.e. US dollars/Japanese yen.  Thus, as USD/JPY falls in value it means it takes fewer yen to buy one dollar; that is an appreciation.  At the moment the yen is trading at around 112.50 to the dollar—it takes 112.50 yen to buy 1 US dollar.  We expect the yen to rally strongly in 2018 and are targeting 100, or par, for USD/JPY.  Here are three reasons why…

  • First, sentiment is extremely negative for the yen.  Because it is often difficult to identify what is driving a currency at any single in time, one of the best and simplest measures to follow is sentiment.  Now, a sentiment measure can be seen to move as a currency trends; i.e. a strong trend develops positive or negative sentiment naturally as more traders add to the trend.  It seems the best use of sentiment is when you can identify historical extremes, and I think we are there in the yen. 

For currencies, because there is little in the way of reliable volume numbers in the spot market, the best single measure of positioning (number of long versus short contracts open for a currency pair) is found on the Chicago Mercantile Exchange (CME) currency futures market.  The Commodities Futures Trading Commission (CFTC) puts out a weekly report of this data. 

Below is a chart prepared by Investing.com which shows net positioning (longs versus shorts) for the Japanese yen over the last five years.  We are into extreme negative sentiment territory with -121.8k positioning measure; i.e. there are 121,800 more short positions than long positions for the average speculator trading JY futures (JPY-USD) on the CME. This seems the wrong skew given the recent weak price action in the US dollar.

 jcjan17-1

Granted, speculative traders aren’t always wrong with their positioning.  But more often than not it seems maximum confidence, measured by positioning extremes, proves the Tao of Markets—Extreme Speculation + Extreme Consensus = Extreme Price.

jcjan17-2

  • Second, the Bank of Japan is starting to reign in some liquidity, albeit slowly so far.  It has been about 15-years since the Bank of Japan drained Japanese yen liquidity from the system.  We have seen years of massive bond-buying, stock buying, and negative interest rates from the Bank of Japan.

On Tuesday, January 8th, the Bank of Japan surprised Mr. Market and decided to trim the amount of Japanese government bonds it purchased; and on cue the yen rallied off this move. 

Higher interest rates will make the yen more attractive for real money traders, thus increasing global demand for the yen.  These comments from the Financial Times quoting and un-named Morgan Stanley strategist:

“With the BoJ cutting the size of its 10-25-year maturity Rinban operation, the focus has returned to the performance of global bond markets and their impact on risk appetite,” say strategists at Morgan Stanley.

“While we would warn against viewing the long-term maturity JGB Rinban purchase programme as an early indication of the BoJ adjusting its yield curve management policy, it does support our thesis of the BoJ aiming for a relative steepening of the back end of its yield curve to provide support for banks and real money investors.”

Granted, the bank only trimmed purchases by about $90 million dollars, but often it is the stuff at the margins can produce a big swing in sentiment in financial markets; and lead to some type of self-reinforcing trend.  And we know from the sentiment data, if sentiment swings it favor of the yen it will represent a lot of buying power.  And at the very least, a decent short-covering bounce.

  • Last, but not least, the yen appears extremely undervalued on a fundamental basis.  Granted, it is difficult to trade on long-term measures of fundamental valuation for a currency; but here again is an area when we often see extremes and need to be alert for a change when we do. 

The valuation for the Japanese yen against the US dollar seems to be in the extreme zone for a major traded currency based on fundamentals. 

Theoretically, these fundamental valuations are determined by what is known as Purchasing Power Parity.  It can be complicated.  But thank goodness for us, the Economist magazine has been tracking fundamental valuations for currencies for many years—it uses its Big Mac Index.  The index measures the local currency cost of a McDonald’s Big Mac in other countries relative to the United States; thus, creating a valuation number for said local currency against the US dollar. 

Below is a recent graph of the Big Mac Index from the Economist.  Note: It shows the Japanese yen is a whopping 37% undervalued against the US dollar.  At a 37% under valuation for the Japanese yen, it implies an exchange rate of 71.70 USD/JPY!

jcjan17-3

Below is our current Weekly USD/JPY chart view:

jcjan17-4

So, those are three reasons why I believe now is the time to play for a rally in the Japanese yen, or a big fall in the USD/JPY exchange rate.

Jack Crooks

Black Swan Capital

9 January 2018


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