Forex Trading Update: USD/JPY

USD/JPY
Before today's close on the daily chart, the USD/JPY had gone up 8 consecutive days in a row. That's impressive considering the last time it happened was in March/April of 2011. The extended move up has mostly been driven by jawboning by Bank of Japan officials, with market participants beginning to price in another round of stimulus. 

In my opinion, the most important thing to watch is how USD/JPY behaves in relation to the 10 Year US treasury note when market sentiment is negative. Typically, during a "risk off" phase, the yield on 10 year US treasury notes decrease. At the same time, the USD/JPY usually goes down as well, as there is a higher real rate of return on 10 year Japanese Government Bonds then there is on 10 year US treasury notes. Now, following this logic you'll realize that if the the 10 year JGB's real rate of return were to decrease and the 10 year US Bond's real rate of return were to be held constant, then there would be less demand for 10 year JGBs relative to its US counterpart during a "risk off" phase. 

I believe what we have been seeing over the last 8 days is a slow continuous change in the expectations of the real rate of return on 10 year Japanese government bonds. Why? Look at the 10 year U.S. Treasury note. It closed with a negative yield change of .0562 today (a 3.10% decrease) and the USD/JPY only dropped 10 pips today! (open to close.) There has been a strong inverse correlation between USD/JPY and a 10YR US Treasury note over the last year; but we may continue to see that correlation weaken in the near future.

Here are the three reasons which I believe have been causing the Yen to depreciate. First, expectations about the Bank of Japan conducting another round of stimulus causes a change in inflation expectations (a lower real rate of return.) Keep in mind, that the BOJ is TRYING to cause inflation as they have been struggling against deflationary pressures.Second, Japan's economy has been slowing down, driven not only by the slowing growth in Europe, the US, and China, but by their recent disagreement with China over a small group of islands. This dispute has fueled nationalistic anger in both countries and has led to Chinese consumers buying substantially less Japanese products. Third, there is a political firestorm brewing in Japan. The government will run out of money in November unless they reach an agreement. Politics over how to refinance there debt has reached critical importance as their Debt to GDP ratio in Japan is now 211%!! As we have seen very clearly in the United States, political disagreements over fiscal and monetary issues can have a big impact on equity markets (i.e. the fiscal cliff)

Let me be clear, I'm not advocating going long USD/JPY right here at the 80.00 level. I'm laying out what I consider to be the fundamental drivers of the Japanese Yen so that you can better understand how future developments may impact the currency.

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