The USD/JPY currency pair, which expresses the value of the U.S. dollar in terms of the Japanese yen, has recently returned to the center of its prevailing trading range. The center of the range is approximately USD/JPY 107; the closing price on June 19, 2020 was 106.85.
The chart below indicates this range, which I identified many weeks back in an article published on April 16, 2020. I also made some reference to this range, particularly the 107 level, in a more recent article published May 15, 2020. My bias for this pair has been generally to the upside, and in fact, subsequent to my most recent article, the pair traded from around 107 to almost 110 (between 200 and 300 pips) with negligible downside.
(Chart created by the author using TradingView. The same applies to all subsequent candlestick charts presented hereafter.)
However, as we can see, USD/JPY has returned to the midpoint of this range at the 107 level. It is interesting that resistance was found right at the top of this range, which served as an excellent exit point should you have identified this resistance early (at just under the 110 handle).
The Japanese yen is managing to “holds its own” against the U.S. dollar in light of the collapse in global interest rates. With the Federal Reserve now at the effective ‘zero lower bound’ (with a short-term rate target of 0.00-0.25%), the Bank of Japan’s comparable short-term rate of negative -0.10% is no longer distant. This collapse in global interest rates occurred in the first quarter of 2020, as central banks began a wave of significant interventions to help improve market liquidity and support their economies in light of the COVID-19 pandemic and associated government interventions (which included vast shutdowns of businesses).
Therefore, the U.S. dollar can be expected to largely trade in a range for the time being, since there is not too much appeal in being short Japanese yen to purchase U.S. dollars for the interest rate differential (which is now practically non-existent, especially when one includes the costs of bid-ask spreads and FX brokerage fees, etc.).
On the other hand, the U.S. equity market appears to remain the most popular equity market in the world. The sheer size of the U.S. equity market offers the greatest opportunity for capital to move quickly, without distorting prices in the short term. The size of the market begets greater size in this fashion. It also remains popular among Japanese investors, especially recently. While we saw some U.S. equity outflows among Japanese investors heading into 2020, data from the U.S. Treasury Department indicates that Japanese investors purchased $2.34 billion of equities in March 2020, and $2.44 billion in April 2020 (the second-highest reading in five years).
Data from the U.S. Treasury also tells us that Japanese investors are also flooding the U.S. bond markets, acquiring $2.39 billion of corporate bonds in April 2020 alone, although outflows in treasury and agency bonds brought the net inflow to about $1.6 billion in April 2020 (but this followed a net inflow of $30.7 billion in March, and $17.5 billion in February).
We could say that net inflows have fallen substantially since March and February, overall, but I think the key at the moment is to look at the equity and corporate bond inflows. The fact that these remain high and positive suggests the Japanese investors continue to favor U.S. capital markets, particularly risk markets (corporate debt and equities). This tells us that in spite of global interest rates collapsing, we can continue to expect Japanese investors and institutions to search the globe for yield, and the United States happens to remain an attractive option.
While central banks may have eliminated concerns surrounding market liquidity, and this has created some USD weakness in recent times, these factors affect JPY in a similar fashion since JPY tends to strengthen as a conventional safe haven on the back of market liquidity issues and USD demand. Provided that the world economy continues to gradually recover from this recent episode, and provided that market conditions remain generally healthy (though preferably not euphoric, which can create its own issues), we can see both USD and JPY possibly finding some continued weakness.
However, independent of USD and JPY indexes, healthy markets and risk sentiment are likely to help USD/JPY regain its stature as a more predictable “risk-on” currency pair. That is to say, the pair is likely to begin to establish a stronger positive correlation with risk assets such as U.S. equities, particularly using evidence from the U.S. Treasury; the more equities rise, the more we are likely to see Japanese inflows (whether it is cause or effect, or both). As Japanese traders and investors continue to view U.S. risk markets in a positive light, we should generally favor USD/JPY upside.
As illustrated in the chart presented above, the current trading range for USD/JPY is roughly 105 to 110. The recent resistance found at the top of this range may tempt one to consider the possibility of the pair finding 105. While this is possible, especially in a ‘shock’ scenario, I don’t personally see this materializing next. Provided risk sentiment generally remains positive, and the trend does in fact remain positive, we should view USD/JPY with optimism.
This means that 110, in my view, is more likely to be found next (once again) versus 105. If or when this occurs, we will need to watch for the potential for USD/JPY to break out of this range; another sign of resistance would indicate that the 110 level may serve again as an ‘exit point’ for USD/JPY traders. Nevertheless, a breakout of this range (above 110) could also be entertained, although we should also be monitoring U.S. equities (perhaps particularly S&P 500 E-mini futures) for key levels and/or euphoria. Should the S&P 500 approach its all-time high of just under 3,400, for example, USD/JPY may be at risk of a short-term breakdown (should resistance be found at this key area).
Due to the apparent importance of U.S. risk asset prices to Japanese yen prices, we can also monitor the S&P 500 in terms of Japanese yen. The S&P 500 is in fact an index, not an instrument; it is merely a mathematical value, and is not expressed in U.S. dollars. However, we can look past that for now, by multiplying the index value by the price of USD/JPY. Making a notional or conceptual assumption that the S&P 500 is USD-centric, we can multiply it by USD/JPY to get an FX-adjusted value. We can then apply 50-day, two-standard deviation Bollinger Bands around this adjusted value (as shown in the chart below) to get an idea of how strong U.S. equities are trading in relation to Japanese yen strength.
As can be seen in the chart above, U.S. equities are quite likely to sell off when the S&P 500 index approaches a level that (“expressed in terms of Japanese yen”) is relatively high (i.e., outside two standard deviations, in relation to the past 50 trading days). I use 50-day bands here due to the slightly longer-term perspective that I feel is more realistic for how longer-term international investors in equities would be looking at U.S. markets.
We can see from the chart above that the recent, minor correction in equities (on June 11, 2020) followed several trading days in the beginning of June that saw the S&P 500 (adjusted in terms of Japanese yen) break out of its 50-day, two-standard-deviation Bollinger Bands. We should keep an eye on the potential for more euphoria as risk sentiment remains positive. Nevertheless, as it does remain positive, we should continue to expect equities to perform relatively well, and for the Japanese yen to favor downside. We should prefer USD strength over JPY strength, independent of how these currencies might favor more broadly in currency markets.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.