To the financially uninitiated, the fact that the Japanese currency and Japan's major equity index have been tending to move in opposite directions may seem especially puzzling. However, the explication of this odd financial phenomenon is more of an exercise in human psychology than economics, inasmuch as the two can be distinguished. Why on Earth would the Yen strengthen as its stock market tumbles? The reasons are similar to those that caused the US dollar to surge on bad US job numbers last summer. The so-called home bias, is at work. Whenever risk sentiment is hampered, investors turn to what they know. We saw it over the summer as US funds sold off foreign assets, European or otherwise, amid the Eurozone crisis, and we are seeing it today as Japanese names are diving into JGBs. The result is a strange inverse on the FX market. When major countries get into trouble, sometimes there own currencies will strengthen as local investors flee into home country government bonds.
According to various stories on the wires, the fate of the Yen is now firmly in the hands of large Japanese life insurers and pension funds. These funds will be under enormous pressure generate returns to meet obligations in an ultra low rate environment. This factor, along with a sagging Nikkei and doubts about Abenomics, could push these funds to turn to international assets denominated in foreign currencies in order to boost yield. Certainly, structural capital outflows would hammer then Yen, but for my part, I haven't given up on the BoJ. The markets are still waiting for "unlimited monetary stimulus," and aggressive plans to implement large scale asset purchases will set off a fresh round of Yen selling. Of course, as discussed earlier, foreign inflows hoping to cash in on a further rally in the Nikkei would be a major concern for anyone looking to sell the Yen. However, it seems doubtful that any inflows from foreign purchasers of Japanese equities would counteract the fleeing and hedging done by corporates and other market participants on the back of any big BoJ easing announcement. It is also highly likely that foreign funds would short the Yen as hedge against currency risk if they initiate any long trades on Japanese equity markets.
Positioning for the week ahead, its all jitters as markets await US non-Farm Payrolls this Friday. I booked profits on my short USD/MXN positions expecting a rally, and the decision is working out nicely. I look resell this pair at 12.40. USD/JPY continues to be slammed as JPY is gaining against virtually everything. Alas, I was stopped out at cost on a long CAD/JPY position this afternoon. Right now the market is definitely all about the US against the rest. North America sold off today, (even USD/ZAR fell 600 pips) but it still looks like the western hemisphere is well positioned for the rest of 2013.
Finally, a more interesting question is if the recent rally in EUR/USD suggests that this pair has bottomed above my earlier 1.25 target. I refrained from shorting this pair precisely because I still think the longer term trend is up despite any short term pain. Aggressive traders may look to establish a small long position and continue to buy on the way down should the rally fade. While I am loathe to use technical analysis, a safer strategy may be to wait for the pair to reestablish a foothold above 1.30 before going long in order to ensure that the trend is firmly higher.
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