Yen outlook

Despite the recent dollar/yen volatility, the pair has remained within a roughly 118.00/112.00 range since late August (Figure 1). With the yen remaining captive to the whims of global carry trade players, movement in the Japanese currency will remain dependent on overall levels of market volatility and global risk appetites.

For now, currency strategists agree that economic and political fundamentals will have little impact on the overall action of the Japanese currency.

“It looks like we’ve shifted into a 113-118 range,” says Thomson FX Hub’s Coleman. “And 118 has become a formidable barrier. I’d be selling rallies in dollar/yen and euro/yen.”

Forex.com’s Dolan has been monitoring the CBOE Volatility Index’s (VIX) correlation with the yen carry trade (Figure 2).

“The VIX had been averaging around 12-15 in June [as dollar/yen was rallying into the 124 region],” he says. “At the peak of the market turmoil in August, the VIX soared to 37.5 as yen carries were dropped.”

In early October, as volatility retreated, the VIX dropped back to the 15-18 region. However, on Oct. 19, the VIX had surged above 22 when the U.S. stock market turned sharply lower.

Dolan suggests forex traders monitor the VIX as a potential timing tool for yen carry trades.

“On moves above 18-20 in the VIX, it might not be a good thing to be looking at the yen carry trade,” he says. “It is very much a real-time situation. If you’re trading the yen, you’ve got to be watching the equity markets.”

Implied volatility in three-month dollar/yen options is another measure forex traders could monitor. Ideaglobal’s Powell has been watching this indicator in recent weeks, noting a recent summer implied volatility low at 6.7 on July 20. However, in mid- August, as the dollar/yen pair retreated below 112.00, implied volatility soared to 14.9. As of Oct. 18, implied volatility stood at 9.1.

“We are still in a period of elevated volatility, although it has calmed down from the August peak,” Powell says.

Forex traders are well aware that low volatility is ideal for successful carry trades. Otherwise, price spikes can wipe out the profits from bullish interest rate differentials.

“We expect volatility to remain elevated between now and year-end, which should keep the dollar/yen below 120.00,” Powell says.

Ideaglobal forecasts the dollar/yen at 112.00 at the end of 2007, and at 110.00 at the end of the first quarter 2008.

“If there is further turbulence in U.S. equity markets it would not be a good time to be long the dollar/yen,” Powell notes.