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Currency Forecast
USD/JPY Outlook
Interest rates and oil pushed the yen to multi-year lows against the dollar in 2005. At the beginning of May, USD/JPY traded at 104.18, but by December, the pair hit 121.38 with the dollar rising a full 1700 points higher turning the yen into the worst performing major against the greenback in 2005. The decline of the yen is a testament to the power of the carry trade as US rates rose in 2005 from 2.25% to 4.25% creating a 425 basis point interest rate differential between the dollar and the yen. The critical question facing traders in 2006 is whether this spread will continue to widen or will it be the end of the great dollar carry trade? As we enter Q2 of 2006, it is becoming imminently clear that the power of the carry trade is losing its punch. Although US rates continued to ratchet upward in Q1 of 2006, rising to 4.75%, the pace of future increases is expected to slow materially, with most market participants anticipating one. At most, two additional 25bp rate hikes that may take the Fed funds rate to a maximum of 5.25%. Jobs will be the key determinant in just how far the Fed will go before pausing. 200K+ of new jobs per month appears to be the metric that will allow the Fed to be more hawkish. Should new job creation fall significantly below that barrier for several months running, Fed tightening will likely cease and along with it the salad days of USD/JPY carry trade as the interest rate differential between the two currencies will no longer expand. For its part, Japan finds itself on the cusp of ending its decade long battle with deflation. Japans Corporate Goods Price Index has increased for 8 straight months in a row while Tokyo CPI has been positive since the beginning of 2006 after declining relentlessly in 57 out 60 months since 2000.
QEP Overis ZIRP Next?
In Q1 of 2006, the Bank of Japan finally abandoned its Quantitative Easing Policy (QEP)the practice of flooding the Japanese banking system with more than 35 Trillion yen in reserves in order to maintain liquidity in the systemas the Japanese economy finally demonstrated signs of sustained growth and the Nikkei rallied above 17,000 for the first time since 2000. The move away from the QEP was the first step in ending the ultra accommodative monetary policy that has characterised BOJ actions for the past decade. The second and far more powerful monetary change is the removal of the Zero Interest Rate Policy, but up to now, the Central Bank has offered few clues as to the time-table for the eventual increase in repo rates. In fact, at the end of the latest BOJ Meeting, Governor Fukui remained noncommittal, stating that he had no preconceptions on when to end the current zero interest rate policy. Governor Fukuis reticence stymied some of the expectations of yen bulls for a near term change, but given the pace of Japanese growth, the market now anticipates that the BOJ will not wait much longer than July before changing interest rate policy.
Clearly, the strong yen is damaging
the economic performance of the most export sensitive of the G-3 nations and
Japanese authorities are becoming increasingly uncomfortable with the yen rally.
The problem is exacerbated by the global slowdown in demand for key Japanese
goods such as electronics. Recently, Vice Finance Minister Koichi Hosokawa said
Japan, "will act aggressively' on any rapid moves in the yen. Yet up to now no intervention has taken place and yen bulls have been emboldened in their USD/JPY shorts. Many traders believe that the BOJ will not intervene until USD/JPY rate falls below 100. Corporate restructuring and increased trade with Asian partners puts Japanese firms in a less vulnerable position than the year before. This has given the Japanese government a bit more leeway to delay intervention in 2004.
Japanese Growth Improving
One of the principled differences in Q1 of 2006 was the continued improvement in Japanese economic growth. While the corporate sector has been healthy for some time with capital spending increasing at near double digit levels, it was the Japanese consumer that has finally awakened from a multi-year slump as the countrys growth translated into ultra-low unemployment rates of 4.1% and improved consumer confidence. In fact, the Eco-Watchers surveya key measure of man in the street sentimenthit a 6-year high, registering a reading of 57.5 in the latest poll. The news bodes well for future Japanese consumption growth and in turn, BOJ willingness to move off the ZIRP standard and consumer spending is the last missing link in the story of the Japanese economic recovery and to that end, the data remains mixed. Retail Trade numbers have been steadily improving with positive results in the last 10 out of 12 months. Overall, household spending, however, has been lackluster at best, registering negative yearover-year readings for every month in Q1 of 2006. This report will be the vital clue to BOJ policy going forward. If rising Japanese consumer confidence can finally translate into positive year-on year-comparisons in Japanese consumer spending, then the groundwork for the near term lifting of ZIRP will be set.
RevaluationYuan or Yen?
The FX world has been focused on the issue of Chinese Yuan revaluation since the later half of 2005. In July of that year, the PBOC actually revalued the Yuan for the first time in 9 years, appreciating the currency by 2.15%. As a result, the yen reacted positively with USD/JPY dropping 300 points in a matter of 2 days. The yen, of course, benefits from Yuan revaluation in two ways: First, as the largest exporter to China, Japan earns more income from its business interests in Mainland China as the Yuan appreciates against the dollar and Chinese companies continue to spend more. Secondly, as the primary trading competitor of China on the world stage, Japan achieves a cost advantage in its products as denominated-denominated goods rise in value. With Chinese exports to the US setting monthly records, the political pressure on the Chinese to revalue remains intense. Senators Schumer (D-NY) and Graham (R-SC) have introduced legislation that would impose a 27% tariff on all Chinese goods. The legislation has been put on hold for the time being, but most market observes believe that further Chinese revaluation announcements will take place as a response to increasing pressure from the Bush administration during the sensitive election year in the United States. Already, the Yuan has set nearly daily record highs against the dollar, trading within a whisker of the 8.0000 level. A fall through that psychologically important barrier may produce a more rapid decline for the pair, which would be bullish for the yen as yuan appreciates further against the dollar.
More Sensitivity to Exchange Rates
While the issue of Yuan revaluation is well known in the currency markets, the idea of yen intervention has not been given nearly as much attention. The recent run up of the dollar against the yen has been a boon for Japanese exporters, as the country has amassed an $80 Billion goods trade surplus versus the United States. Typically, the export-oriented nation has only intervened to weaken the yen, but recent statements by President of the Automotive Trade Policy Council, Stephen Collins, should make traders take pause and consider the opposite possibilities. Mr. Collins stated that "Japan has played this game (of currency intervention) hard and highly successfully and to our industry's, and we think the U.S. economy's, demonstrable harm. We have pushed hard to get much more attention and something more credible, more serious from the Treasury department. While all of the attention has been on the new guy on the bloc, China, Japan flew under the radar screen and has joined in on pointing fingers at China. The reports from the G7 were extremely discouraging and very damaging to U.S. interests. There is no excuse for the G7 to get together and sit around talking about China when the currency imbalances and Japan's policy of strongly encouraging yen weakness isn't even discussed." In the past, Japanese authorities viewed the 100 USD/JPY rate as the critical support barrier. Then the defense line was raised to 110 and finally now many market participants believe that Japans MOF would not like to see rates decline below the 115 level. As time progressed, the level of support for the yen has been ratcheted higher and higher, but if Mr. Collins views become popular during the upcoming election season, the pressure on Japan to conduct reverse intervention could send USD/JPY tumbling, regardless of the carry trade spread.
Conclusion
While 2005 was undoubtedly the year of the carry trade which saw USD/JPY soar to multi year highs, 2006 may see many of those same trends reverse. Better economic growth and more importantly steady increase in Japanese consumer spending could finally motivate the BOJ to abandon its decade long Zero Interest Rate Monetary policy, while the US Fedfaced with a slowing housing marketmay terminate its two-year long monetary tightening policy. With BOJ already abandoning its QEP as it positions to change the Zero Interest Rate Policy, this major shift could give speculators a good reason to abandon their short yen carry trades as we move forward in 2006. Meanwhile, China, pressured by political outcries for revaluation during the upcoming US election season, may be forced to loosen its yuan peg further, sending the USD/JPY lower. On the other hand, if US growth continues its torrid 2005 pace, the Fed may raise short term rates to 5.25% or higher, in which case the carry trade will continue, potentially taking USD/JPY to 130 or higher as a result.
Technical Outlook
The USD/JPY spent the better part of Q1 2006 consolidating its gains of 2005. After experiencing a vicious 800 point sell-off from its 2005 highs of 1.2138, the pair made a spike low at 113.41 on 1/12/06 (the 61.8% Fibo of the 108.75-121.38 bull wave) and then spent the rest of the quarter churning higher. All of the rallies, however, were capped by 119.00 resistance line while volatility compressed markedly as the quarter wore on. Over the past month, the action has become even more contained with most downside moves never extending below the 116.38 level. This represents the 38.2% Fibo retrace of the much larger 108.75-121.38 bull wave while upside forays never made it above the 119.00 barrier with several daily candles forming shooting stars and dojis suggestive of quick rejection of that price level.
As we move into the second quarter of 2006, the USD/JPY is tracing out a very clear ascending triangle pattern, suggesting that the Q1 of 2006 may have simply been a consolidation of the large 108.75-121.38 bull wave of 2005. Ascending triangles typically resolve in upside breakouts, but only a clear burst to the 120.00 level would confirm the resumption of the upside trend. A break below the 116.00 figure, however, would trace out a major distribution top and may target the base of the large 2005 breakout move all the way at 108.00. Indicators, however, point to further upside strength as MACD has made a series of higher lows, but in and of its self, this information provides us with little guidance as price flow could quickly turn the values negative. Finally, the most recent series of lower highs suggests that dollar bulls are losing steam, and the ascending triangle formation may well fail to break out.
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