A Break Decided Between Rate Forecasts and Risk Trends

USDJPY, Rate Forecasts and Volatility Talking Points:

• The Market Perspective: USDJPY Bullish Super 132
• USDJPY developed a remarkably consistent channel, which led to a range-trade-like response from retail traders; but a break will be needed sooner rather than later
• Carry trade appetite is still a strong influence on USDJPY; but with a FOMC plateau seen in the near future, will risk trends take precedence?

Like most of the Dollar-based crosses, USDJPY is struggling to establish a clear direction. There is a dominant bearish trend that developed after the Nov. 10 breakout – conveniently formed as a consistent channel that effectively cut 22 months of bullish advance to October in the span of just 3 months. That said, the past month has seen competing technical barriers rise to slow bears’ momentum while keeping some major bull jumps in check. To the upside, resistance is defined by the trend channel resistance extending back to the all-time high of October 21 and happens to coincide with the 20-day simple moving average in the vicinity of 130.50-25. The block to advance lower is the midpoint of the climb from January 2021 to October 2022, which falls at 127.25. These are quite distinct levels, but I would caution against treating the chart as if its lines are sacred. There are more than a few examples in the market where technical breaks have completely failed to usher in the subsequent technical move that textbooks would suggest (eg the S&P 500 around its 200-day SMA). What we need is fundamental motivation. For USDJPY, the most productive stimulus in terms of correlations was the progress of the growing carry trade. The relationship between the US and Japan 2-year yield spread to USDJPY was impressive through November. Since the exchange rate has pulled back sharply, the carry will be flatter than an inverse rate. With the PCE deflator — the Fed’s favorite inflation gauge — on tap Friday, there may be some incentive to restore this topic to prominence; but the FOMC decision next Wednesday would likely quickly extinguish the momentum.

Chart of USDJPY with 100-day SMA overlaid with the US-Japan 2-year yield spread (daily)

Chart Created on Tradingview Platform

A more practical driver for USDJPY moving forward is the same systemic source that is likely to restore momentum to the markets in general: the undercurrent in risk trends. When we put most other currencies against the US dollar or the Japanese yen, those reference currencies are usually treated as the safe havens in the pairing. But, which currency is the haven in USDJPY? The natural assumption given the load trade is building behind the aggressive tightening regime of the FOMC would be that the Yen would benefit from a drop in risk appetite, which forces a relaxation of the yield-gathering exposure. That said, the correlation between USDJPY and the well-known VIX volatility index (often referred to as the “fear index”) generally presents the opposite scenario. Given the 50 percent retracement on this pair of peak highs, the carry implications are likely to be significantly discounted; which reinforces the more elementary aspects of risk aversion. Given that there is less likely to be a sudden and steep slide in volatility from here, the more powerful scenario going forward would be an increase in risk aversion. If the relationship holds, it would appear to benefit USDJPY by clearing the upper side of its channel. Now, we just need to see if risk trends will catch on.

Chart of USDJPY with 100-Day SMA Overlaid with VIX Volatility Index (Daily)

Chart Created on Tradingview Platform

As we keep an eye on the potential next trend for USDJPY, it is worth considering how retail traders engage the pair. Looking at the IG Customer Sentiment data, we can see that there has been a clear swing from net long to short and back again in different cycles these past two months. It appears that retailers are growing comfortable with the characteristic channel in staging rankings. That’s not a bad approach considering the actions of the market during the period, but a channel will eventually end – and the range consistency along with it.

USDJPY Chart Overlaid with IG Client Position (Daily)

Chart Created at DailyFX