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The Japanese Yen was hammered by markets in the second quarter. USD/JPY shot by the 2002 peak, touching its highest since 1998. A key driver of the Yen’s weakness has been the Bank of Japan’s policy divergence from its major peers. While central banks like the Fed and RBA gave surprise hikes, the BoJ remained persistently dovish, making life difficult for its currency. On the chart below, USD/JPY can be seen rising as US Treasury yields outpaced their Japanese equivalent. Could this change ahead?

Japanese Yen Fundamental Drivers

Chart Created Using TradingView

Rising Inflationary Forces

A key reason why the BoJ reaffirmed its ultra-loose policy is low Japanese inflation. This has been slowly changing. Local CPI was 2.5% y/y in May, above the central bank’s 2% target. The BoJ has historically struggled to bring inflation in target. Some of this is likely due to reasons outside of its control, such as demographics. But even Japan is starting to feel the pinch of rising prices. The island-nation economy is the world’s 4th largest consumer of oil, which has become more expensive.

In the second-quarter Yen outlook, I tried to predict Japanese inflation based on crude oil and coal, also factoring in time. By removing the lag from CPI data, I could use recent energy price data to estimate where Japanese inflation could go in the coming months. The approach correctly estimated inflation breaching the Bank of Japan’s 2% target in Q2. In this article, I revisited the original multiple linear regression model and simplified it by taking out the impact of coal. I then built a second model that tries to consider the Yen’s devaluation. But more on the latter shortly.

The first model below has an R-squared score of 41%. In other words, only 41% of the variation in Japanese CPI is explained by crude oil and time. More to the point, it greatly underestimated the actual CPI in May (0.97% y/y expected versus 2.5% printed).

Estimating Japanese CPI – Model 1

Source: Bloomberg, Chart Prepared by Daniel Dubrovsky

Will a Weak Yen Translate into BoJ Action?

The second model below tries to predict Japanese CPI by also factoring in the Japanese Yen and holding constant G20 CPI. This is to see if a devalued currency could be an inflationary force for the island-nation economy. This model has a higher R-squared at 60%, meaning that 60% of the variation in Japanese CPI is explained by the variables. The higher accuracy of the model suggests the Yen could be a key factor in driving inflation. Without the Yen, the accuracy drops to 53%.

This model still underestimated actual CPI in May (1.8% seen versus 2.5% printed). It does see a slowdown in early Q3 before inflation rises back to target. It will remain to be seen if the BoJ will spring into action. A general rule of thumb for traders is to not fight central banks. As such, a dovish BoJ should still work against the Yen. But, a combination of inflation near target and rising concerns about JPY’s level could perhaps help stabilize the currency in the months ahead.

Estimating Japanese CPI – Model 2

Source: Bloomberg, Chart Prepared by Daniel Dubrovsky

‘When life gives you lemons, make lemonade’

A lot of traders look for breakouts and sharp moves to boost their P&L, and in a lot of cases make a great success of this. However, trading defined ranges can potentially offer more than one opportunity when looking at different assets, and when you have strong levels of support and resistance your chances of trading profitably can actually increase as you may have the opportunity to both buy and sell your asset as it touches both support and resistance. When range trading you are also aware of when not to trade, especially if price action is gathered around the center of the range. Sometimes when there is unexpected news on an asset class, traders may jump on the trade, but if this asset is in the middle of a trading range it may be prudent to see if either support or resistance is tested before making a trading decision.

EUR/CAD Daily Price Chart

Chart via ProReal Time

One pair that looks as if it has set a solid trading range over the last two-and-a-half months is EUR/CAD. Both support and resistance have been tested and held on multiple occasions since the range formed with reactions from these levels also being reasonably quick. Both support and resistance levels can be used by traders to help set invalidation levels with the four-point trading range allowing a slightly more flexible approach when setting stop losses. Both the Canadian dollar and the Euro are likely to be volatile over the coming months as both sides look to re-set monetary policy to fight off inflation and this may provide further opportunities to test the current range.

AUD/JPY made a 7-year high in early June at 96.88 then pulled back to the just under 92.00 before settling back into a range. Broad Yen weakness has been seen across the board with USD/JPY hitting a 24-year peak recently.

The monetary policy of Japan’s Ministry of Finance (MoF), and by extension the Bank of Japan (BoJ), is going the opposite direction of other global central banks, with the exception of the People’s Bank of China. The BoJ recently committed to extending their yield curve control program (YCC) and are close to holding 50% of all Japanese government bonds (JGBs) on issue.

The RBA on other hand has recently committed to a more aggressive tightening path for monetary policy than previously anticipated by the market. It hiked by more than the consensus for the May and June meetings and there is little to say that this won’t happen again.

Second quarter Australian CPI will be released 27th July. It was first quarter CPI coming in at 5.1% year-on-year that prompted the RBA to lift rates. First quarter CPI was 2.1% quarter-on-quarter. The 2021 Q2 CPI was 0.8% and this will be dropping off the annual number this time around.

Observing the energy and agricultural markets over the second quarter, it is shaping up to be a print larger than 0.8%. The surge in futures prices of these commodities occurred at the end of March when Russia invaded Ukraine.

The flow through effect into the real economy was only felt after a month or so after those dramatic price rises. Certainly, anyone living in Australia would have been shocked in the supermarket and at the petrol bowser through the second quarter.

This is the period that the Australian Bureau of Statistics (ABS) will be measuring consumer price changes. The market may not be fully cognizant of the probability that the July CPI print could be much larger than the RBA would like.

RBA Governor Philip Lowe has made it clear that the bank is ready to act decisively if warranted. A jumbo hike in August, on top of the rises in May, June and July, should not be ruled out.

The Australian fundamental backdrop remains strong with low unemployment, solid growth, positive international trade and debt at relatively tame levels, publicly and privately. The market is not focused on that for now, monetary policy appears to be in the driver’s seat. The aggressive hawkish stance from the Federal Reserve has seen the US Dollar rally and AUD/USD has been pummeled in the melee.

AUD/JPY on the other hand, could have some favorable tailwinds about to pick up.

Buy near 93.25, stop loss at 91.25 and take profit at 96.45. Additionally, if Japan changes monetary policy or actively intervenes in the FX market, exit the trade. Developments in China should also be monitored for macro implications and could also trigger an exit from the trade.

AUD/JPY Chart

Source: TradingView

Passing into the second half of the trading year, there is considerable upheaval in the fundamental backdrop. All but the technical analyst purists recognize the implications for trade opportunities. With systemic threats of rampant inflation, aggressive interest rate policy and rising fears of recession, it is likely that the normal slide in ‘summer doldrums’ is replaced with unseasonal volatility and heavier pressure for general risk aversion. Risk aversion was not an unfamiliar sight through the first half of 2022. The Dow and S&P 500 pitched lower from record highs almost from the start of the year on their way to ‘bear markets’. Yet, despite this and so many other measures of risk in strong trends lower, USDJPY and the Yen crosses managed to head higher.

Chart of USDJPY with 100-Day SMA and 100-Day Rate of Change (Daily)

Chart prepared by John Kicklighter, created with IG Platform

One of the unique aspects of the risk aversion that we have seen in this new cycle is that it comes alongside a sharp reversal in global monetary policy. Up until this year, the world’s central banks were flooding the system with money via near-zero interest rate policy and massive stimulus programs. As that largesse is retracted, sentiment reverses but so too does the potential to collect ‘carry’ as yields rise. As the West raised rates aggressively and the BOJ attempted to keep its policy anchored, appetite for return managed to offset the sense of self-preservation for capital. I don’t think that will last moving forward. Should risk aversion deepen, even the hearty yield forecasts through year-end won’t offset the potential exchange rate volatility. Further, it is likely that the BOJ cannot keep up its isolated dovish policy especially as the government worries about the Yen. I will be looking for signs the market is committing to a turn with taking out levels like 132 and 126.

Chart of USDJPY with 100-Month SMA (Monthly)

Chart prepared by John Kicklighter, Created with IG Platform

When it comes to exchange rates, there is always a relative value that comes into play to define which way the capital is flowing. Relative growth and risk exposure represent key fundamental themes that drive the market; but through the first half of 2022, the principal driver of the FX ‘majors’ has been monetary policy and rate forecasts. Notably, where rate forecasts are relatively close (eg USDCAD), there has been relatively modest trend. EURUSD on the other hand has seen a significant decline of as much as 10 percent through the first half as the ECB attempted to avoid tightening rates while the Fed stepped on the accelerator. A considerable differential was priced in between these two principal economies around April/May, but the tides started to turn into June as the ECB realized it couldn’t avoid the inflation fight any longer.

Central Bank Monetary Policy Standing and Year-End Forecasts

Chart Created by John Kicklighter

Looking out over the second half of 2022, it is very likely that the Fed will continue a course of significant rate hikes while the ECB wavers on how to start its own tightening regime and at what pace to keep it going. The Dollar’s premium is unlikely to grow significantly more exaggerated than where it was at the midpoint of the year. Should rate differentials and growth trajectories remain on relatively similar courses, I will look for EURUSD to hold up the 1.0635 floor stretching back nearly two decades. A normalization of trend is likely to see some movement back into the broader range up to 1.2150/1.2000. The wild card is the intensity of risk trends. Should risk aversion grow extreme, the Dollar’s safe haven appeal could force a break.

Chart of EURUSD with 50-Week SMA (Monthly)

Chart prepared by John Kicklighter with TradingView Charts