Yen breakout

The day before Thanksgiving (Nov. 24), rumors were swirling around the yen, including European officials complaining (after the September G7 meeting) about the yen being too weak vs. the euro.

The Japanese response was ambiguous. While admitting the weak yen was “rough” for European exporters, the Japanese Ministry of Finance said the usual stuff about exchange rates being set by the market and the need to follow fundamentals. They claimed to be puzzled themselves, since the Japanese economy was in a multi-year recovery phase. The implication was that Japan would not raise interest rates to please the Europeans until the Bank of Japan (BOJ) was good and ready to raise rates for domestic reasons — and the bank would not intervene in the forex market, either.

In fact, the official Japanese Cabinet Office “assessment” of the economy on Nov. 22 was a downgrade.

Normally this would be yen-negative, since it suggests a BOJ rate hike is even further off in the future.

The yen had been in a downtrend since it peaked on May 17 at 0.9442. But when the market opened in the U.S. on Nov. 22, the yen gapped higher on the open at 0.8584 from the previous day’s close at 0.8514. Aside from the observation the yen is undervalued by the most it has been since 1985 (when the Plaza Accord artificially engineered the dollar down and the yen and other currencies up), there was no hard, specific reason for the gap up and the higher yen high. Searching for the purported cause, we find only that U.S. weekly unemployment claims released that morning were higher than expected. The University of Michigan consumer confidence index fell a bit when a small rise was forecast. Some traders jumped to the conclusion a Fed rate cut was closer than imagined the day before. If so, a narrowing of the yield differential favors the yen, even though the 10-year differential is a whopping 2.90 percent.

But wait a minute. This new information doesn’t pass the “So what?” test. Weekly unemployment claims and the University of Michigan consumer confidence index are second- tier data. We shouldn’t be drawing any conclusions about Fed policy from second-tier data, and even if the market is making the correct deduction — that the Fed will be cutting rates soon — the yield differential will remain very, very wide. For some traders to be dropping out of the yen carry trade on this evidence is an overreaction. Possibly it is true that some hedge funds have taken big losses on the recent downward correction in oil and other commodity prices and need to raise a little cash from profitable positions, but the new data is no real threat to the carry trade.

It shows that in addition to an opening up-gap, the new yen price bar was outside the top of the linear regression channel. In fact, the yen had been pressing against the top of the channel for three weeks already, and had penetrated it for a few days in early November. The opening up-gap is considered a reliable indicator — why should we care if the background story is full of holes? If you were a day trader and jumped opportunistically on the gap, you could already be out with a nice little profit.

This might be true, but do you know what to do on the next trading day? This particular technical move was a surprise, and you can’t count on surprises. The only way to have confidence in your next trade is to know the fundamental context, and in this case the context did not support a continuation of the breakout move.

However, it didn’t support selling the yen in line with the overall downtrend, either. As it happened, the next trading day (Nov. 24, the day after Thanksgiving) delivered another giant upside breakout move. This time there was news to support the move: the announcement of a trip to China by an unprecedented number of high U.S. officials (including the U.S. Treasury Secretary and Fed Chairman, plus an unusually large number of other cabinet officials) to discuss raising the value of the renminbi (yuan), which by definition would lower the dollar.

This is going to be a historic event. The last time two countries got together regarding currencies was the late 70s when the U.S. and Japan met and Japan eventually agreed (in 1980) to a “voluntary restraint” on auto exports to the U.S. Does the move coming before the news mean the news was leaked? Not necessarily. The market was very thin around the holiday and once the rock started rolling downhill, it hit stops left and right. The important point is the fundamentals are now supporting the technicals, and that’s a more comfortable place from which to trade. We can draw a new channel with confidence the new direction is correct.