Forex Trading Update: USD/JPY

Last night at 7:30 PM EST the Japanese CPI numbers came in better than expected.

Tokyo Core CPI y/y        Actual: -0.4%,   Expected:    -0.5%,   Previous: -0.4%
National Core CPI y/y     Actual: -0.1%,   Expected:    -0.2%,   Previous: -0.3%

Check out a chart of Japan's inflation rate here.

As we know, the Bank of Japan has been struggling with deflation and these better CPI numbers came as good news to the BOJ. Since the news came out, the Yen immediately appreciated against the dollar and has been trending down since then. It fell from 80.33 at the time of the announcement to 79.50 at 10:00 AM EST.

To understand why the Yen was appreciating today, we first need to look at why it has depreciating over the last 2 weeks. USD/JPY has been ripping up since Oct. 11th when the Bank of Japan began jawboning about injecting more stimulus into the economy. The BOJ then began dropping hints that the actual size of this latest round of QE would be substantially larger then what market participants had been expecting (10 trillion yen to 80 trillion yen.)

The Bank of Japan is engaging in quantitative easing for two reasons: The first, to devalue their currency to aid their exporters. A weaker Yen makes exports from Japanese manufacturers cheaper for foreign buyers. This is critical for Japan's manufacturing base as the country is an export based economy. In addition, there has also been an immense amount of political pressure on the Bank of Japan to help exporters. (I like to think of this in terms of big oil companies sending lobbyists to Washington.)

The second reason is to try and increase inflation. Inflation of 2.0% - 3.0% is typically considered normal for a healthy developed economy. If inflation were to increase, that would in turn lower the real rate of return on Japanese Government Bonds (JGBs) and cause the demand for these bonds to decrease. What happens when the real rate of return on these bonds decrease? There will be decreased demand for these bonds during periods of risk aversion as investors move their money into safe havens. (Safe havens = US 10YR, 10YR JGB, Swiss banks, etc.) - The decrease in the real rate of return on the JGBs will cause a significant amount of money to flow into other safe havens that would normally flow into JGBs.

So how do we trade this? I think we need to wait for guidance from the BOJ on Tuesday. They will be issuing a statement on monetary policy, making a decision on the overnight call rate (you can check for this here), and holding a press conference. The important thing to realize at this point is that the rules of the game may be changing. In the near future, it's very possible that the Yen does not appreciate against the dollar (USD/JPY down) during periods of risk aversion. We've been seeing evidence of this since last week.

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