Dollar/yen background

The recent history of the USD/JPY rate illustrates how candlestick analysis has been a useful tool during sharp swings in this currency’s direction. The dollar/yen market is particularly sensitive to candlestick analysis, given Japan runs a substantial basic balance of payments surplus.

Although short-term capital outflows tend to weaken the Japanese currency, any drop in these flows can result in rapid yen gains, reflecting an underlying over-supply of dollars in the market. There is the potential for extended dollar rallies punctuated by very sharp corrections.

The dollar remained under pressure in early 2005 as confidence in the U.S. currency remained very weak and the Bank of Japan (BOJ) intervened to curb yen gains toward the 100.00 level vs. the dollar. Over the course of the year, however, the U.S. Federal Reserve increased interest rates at successive meetings of the Federal Open Market Committee (FOMC), while the BOJ left interest rates effectively at zero to combat deflationary pressure in the economy.

Although U.S. interest rates had been kept at 1.0 percent, the dollar was a clear target for short sellers (even with short-term Japanese interest rates at zero) because the yield was limited. The equation, however, continued to change gradually during 2005 as the interest-rate differential widened, with U.S. shortterm rates rising to 4.25 percent by the end of the year.

The dollar became much less attractive as a global funding currency while there were increasing temptations to sell the yen (even with rates at zero) as the Japanese currency became the focus of attention as a global funding instrument. There were further outflows of capital into higheryield instruments such as Uridashi bonds issued in New Zealand dollars.

Japanese economic data during the fourth quarter of 2005 was generally positive, with gains for production and employment and evidence of a slow emergence from deflation. The capital account data recorded strong inflows into Japanese equity markets, while evidence from speculative positions suggested an increasing short yen position.

The USD/JPY rate pushed to highs around 114.00 in the third quarter before weakening back to near 110.00 as the yen was boosted initially by the Chinese yuan revaluation in July. The dollar also hit short-term selling pressure after Hurricane Katrina hit the U.S. Gulf Coast in late August. The dollar/yen recovered quickly, however, and pushed above the 115.00 level.

Yen losses vs. the dollar accelerated during the fourth quarter as widening interest-rate spreads encouraged further dollar buying, and the dollar/yen pushed above 120.00 by the beginning of December.

Daily candlestick signals were generally dollar bullish during November, but a closer look at the USD/JPY chart shows some warning signs. “Candlestick pattern summary” defines the patterns discussed in the following section.