With U.S. Treasury yields extending upwards and the Nikkei up 1.92% overnight, the dollar hit its highest level against the Japanese Yen in 4 months. All of the Yen crosses benefitted from this move but EUR/JPY in particular rose to a fresh 4 year high, GBP/JPY to a 5 year high and CHF/JPY to 23 year high. For USD/JPY, 100 is now in the rearview mirror and after today’s comfortable breakout, FX traders are wondering how high will the currency pair rise. To address this question, we will look at fundamentals, technicals and positioning.
From the perspective of fundamentals, we have long said that U.S. rates are headed higher and as long as this remains true, USD/JPY will rise. Our patience has been tested for the past few months with the pair struggling below 100, but USD/JPY is finally experiencing upside momentum as the prospect of tapering nears. Regardless of whether the central bank chooses to reduce asset purchases in December, January or March, there is no question that they will start paring stimulus within the next 4 months. More importantly, when they announce their plan to reduce monthly bond purchases, it may include a schedule to bring asset purchases to zero. Last year Bernanke said Quantitative Easing will end in 2014 and given the urgency heard in the voices of some policymakers who vote next year, we believe they will stick to this timeline. This means the dollar will not only receive support from a tapering itself but also the prospect of QE ending. The following chart shows the relationship between USD/JPY (Gold line) and U.S. 10 year yields. By mid 2014, we expect 10-year Treasury yields comfortably above 3% and closer to 3.5%, which would be consistent with 105 in USD/JPY. Of course, this does not remove the possibility of a retracement before this level is reached especially if investors need to adjust their expectations for tapering in 2014 instead of 2013.
This next shows the relationship between USD/JPY and the Nikkei. With monetary policy in Japan expected to support equities throughout the next year, further gains in the Nikkei should also promote a stronger rally in USD/JPY. As we have seen in the most recent trade numbers from Japan, imports are rising because of the recovery and this trend is expected to continue. More foreign imports by the Japanese means more Yen outflows. The rise in U.S. yields in 2014 should also accelerate foreign investment by Japanese retail and institutional investors. In fact, retail investors became net buyers of Uridashi bonds (foreign bonds) in October for the first time since November 2012. The most significant risk for Japan however is the consumption tax hike. If spending contracts significantly, the Nikkei could reverse its rise but the Bank of Japan would most likely respond by increasing stimulus.
From the perspective of positioning, the latest IMM report showed short Yen positions near a seven-year high. Speculative positions have continued to build over the past few weeks with Yen short or long USD/JPY positions at their highest levels since 2007. When we have positions at such extreme levels, the currency pair is very vulnerable to profit taking on any sign of weakness. The following chart shows extreme shorts in IMM positioning and the corresponding reversal in USD/JPY.
Nonetheless from a technical perspective, USD/JPY has broken out of a tight consolidation. Taking a look at the monthly chart, the next level of resistance is above 103. The May high is 103.73 and the 38.2% Fibonacci retracement of the 1998-2011 sell-off is right below that level at 103.30. So from a Fundamental and Technical perspective, we expect at least another 3 to 5% move higher in USD/JPY as long as it does not drop back below 100.