Strategy: Sell Dollar to Yen Exchange Rate to 108.50 Target

Brokers TD Securities have put out a call for the USD to JPY exchange rate to break lower and extend to a target at 108.50.

• TD Securities see good risk / reward on selling USD/JPY
• But, is the trade already overcrowded?
• Intesa Sanpaolo argue the risks are actually skewed in favour of the dollar

“We think short positions in USDJPY offer a compelling risk/reward profile. We are targeting a move below 110 and think an extension toward 108.50 is possible. We advise placing stops above 114.55. Ideally.”

After consolidating at the 113 level for several weeks they think the “time is ripe” for the pair to break lower and renew its down-trend, particularly after the FOMC delivered a dovish, and therefore dollar-negative forward guidance at its March 16 meeting. 

From a technical point of view, they point out how the exchange rate has been forming a triangle pattern at around the 113 level, with strong down-side potential:

“Technically, we think we are reaching the apex of a ‘triangle‘ consolidation pattern. Typically, this is a ‘continuation’ pattern that suggests the price will extend in the same direction as the prior move.”

According to their Elliot Wave analysis, the chart is showing the triangle as the wave 4 of a larger move, with a just-starting final wave 5 still to unfold lower.

Their bearish USD/JPY analysis is further supported by fundamentals which support yen strength and dollar weakness, due to expectations that the BOJ’s negative interest rate policies are destined to fail at bringing down the yen’s exchange rate.

Further they see the Bank of Japan as rapidly running out of options:

“With their QQE programme rapidly approaching its practical limits, we are growing increasingly concerned that Kuroda may be revealed as the first major monetary policy “emperor” to be found a little underdressed. While this points to growing long-term vulnerabilities for the JPY, the initial reaction of the FX market is likely to be risk aversion, supporting additional JPY gains.”

They further see more upside for the yen coming from a widening of trade surplus due to a combination of lower oil prices and higher exports due to the weaker yen:

“Japan’s current account surplus has returned to levels that prevailed before the tragic events in Fukushima, helping to offset portfolio outflows by domestic (and foreign) investors.

“This, combined with other JPY-positive factors, including greatly-improved terms of trade, persistent risk of repatriation flows, and a notable shift in the acceptability of JPY weakness by the international community (G20), leads us to think the yen has further gains in store.”

Key Risk is Trade May be Over-Crowded

TD point out that the key risk to their trade is ‘positioning’ which means there are already a high number of short positions in USD/JPY, a condition which is often a sign a reversal may be close at hand:

“The key near-term risk to our view comes from current positioning. Since mid-December, the market appears to have accumulated a decent short interest in USDJPY. According to IMM data, leveraged accounts are net-short about 10% of total open interest.”

Whilst high 10% open interest is not as high as previous highs of 20-30% note’s the brokerage firm, and so does not preclude further downside altogether.

Most importantly TD are bearish longer term, noting:

“Importantly, we think we are approaching the end of the move lower in USDJPY, as valuation concerns have decreased, positioning is turning less favourable, and the BoJ will be increasingly backed into a policy corner. This suggests a degree of unpredictability in their future policy response functions that could result in an asymmetric set of market risks for JPY longs.”

The Opposite View - Could USD/JPY Rebound Longer-Term?

According to Banca Intesa San Paolo’s chief economist Luca Mezzomo, downside for the USD/JPY pair is limited and they expect the pair to rebounding higher, reaching up to the 120s again on the back of diverging monetary policy between the Fed and BOJ:

“Given the prospect of further monetary accommodation by the BoJ, and of the Fed resuming the rate hike cycle between 2Q and 3Q 2016, we confirm our expectations for a depreciation of the yen by the next few months. In a phase in which the divergence between the BoJ and the Fed is at its height, the exchange rate should return inside the USD/JPY 120-125 range between 2Q and 3Q.”

Cap at 130

Despite their bullish forecast Intesa, nevertheless see a cap for yen weakness at 130.

They see this as a result of a combination of factors – some of which they share with TD:

1. BOJ easing is becoming ineffectual at weakening the exchange rate.
2. Japan’s trade balance is improving due to weak oil and cheaper yen and this could support yen.
3. Fiscal policy would increasingly fill the gap left by monetary – e.g the consumption tax rise is set to be delayed.
4. Inflation in Japan is likely to remain lower than the US further supporting the yen.

The analysis leads to the conclusion that USD/JPY could peak and then move down again as factors above impact.