Japanese Yen: GBP/JPY at Crossroads and Poised for a Break of Major Trend Line

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Yen pairs are surging and the Pound-to-Yen rate, sitting at a destiny-defining level, is no exception. 

The Pound-to-Yen rate resumed its sell off Thursday and is closing in on the 'danger level' of 147.97.

A break below here would be a red flag to a raging bull and a green light for short-sellers that could prompt even further losses for the exchange rate.

This would be a major breach of the uptrend running from the October 2016 lows and breaks below major multi-year trend lines are often very bearish indicators.

As far as estimating downside targets following the break goes, if it happens, the usual rule of thumb is to take the length of the move immediately prior to the break (A) and extrapolate it lower (B).

This results in a downside target of 141.00 eventually, however, a more conservative target would be at the 0.618 ratio of A, at 144.00.

0.618 is known as the golden ratio and is an ancient mathematical constant found to be useful in determining proportions in nature and financial markets.

Sea-Change for the Yen

That the Yen is the strongest G10 currency at the moment is somewhat baffling to analysts.

Normally the Yen would be expected to weaken in a situation where US interest rates were rising and global growth was on the up, since it is a safe-haven currency which means it tends to do well in times of crisis, not growth.

Yet the Yen has deviated from type of late and markets are conjecturing why.

One reason put forth, is that Japanese investment funds are increasingly selling their foreign bond holdings, which because they are mainly denominated in reserve currencies - USD, EUR and GBP, actually results in gains for the Yen against these counterparts.

"The latest data also showed Japanese investors repatriating money out of foreign bonds," remarks ACLS Global chief market strategist Marshall Gittler in his explanation for the Yen's rise.

One reason why Japanese investment funds are heavily selling bonds may be because the composition of their portfolios has changed due to widespread quantitative easing (QE), according to Morgan Stanley strategist Hans Redeker.

QE has changed the types of bonds these funds have bought: instead of stocking up on safe high grade sovereign (government) debt, the Japanese have instead bought riskier corporate debt.

The reason for this is down to central banks who became the main buyers of sovereign debt whilst undertaking QE.

This limited the available supply of sovereign bonds and pushed up the price of the bonds which were available making them too rich for some buyers.

The result is that many Japanese funds decided to purchase riskier bonds instead, bonds, however, which they are less likely to hold onto when markets get jittery.

As inflation starts to rise and errode their expected return funds are selling thier corporate debt which is denominated mainly in USD, EURs and other major reserve currencies.

If they had held soverign debt instead, argue Morgan Stanley, this would not have been the case, as they would have either held on for the term, or sold and bought back in at a cheaper price.

"QE globally has pushed investors to take on more risk. Traditional holders of sovereign debt have been increasing their duration and, importantly, increasingly allocating into credit instruments. The result of this shift is that rising yields have a more acute impact on investors' P&L given their greater exposure to duration and credit risk, when compared to a more conservatively structured sovereign debt portfolio. The implication here is that pressures in this environment to reduce risk are higher," says Redeker.

Rise of the Hedge 

Recent bear moves in the Japanese stock market may also be strengthening the Yen, as it causes Japanese investors to become more cautious and hedge in the currency risk of foreign assets - part of the currency's 'safe-haven' effect.

"JPY seems to be reacting as usual to lower stock markets – Japanese investors tend to increase their currency hedges in such situations, which gives rise to the talk of JPY as a “safe haven” currency," says Gittler. 

For the strategist, the crucial level to watch in USD/JPY is ¥107; if the exchange rate breaks below that before the end of the fiscal year on 31 March, "many Japanese exporters will have to hedge their positions."

"Many of them set their internal budgets assuming a USD/JPY level of ¥110 and placed hedging orders to sell USD/JPY if it breaks below ¥107," continues Gittler, thus a break below the key level would probably add fuel to the downtrend.

Japanese Export Effect 

Another facet of the Yen-rising story also appears to be expectations of increasing exports to the US.

The increased fiscal spending and tax cuts recently announced in the US, at a time when employment is at record high levels and the economy is growing at a healthy clip, will put money into consumer's pockets which they will probably spend on imports - a fairly sizeable proportion of which come from Japan.

This is likely to see the increased demand for Japanese exports and a rise in the Yen versus the Dollar.

It's part of the logic which underpins the twin deficit model for why the Dollar was falling recently despite rising interest rates.

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