USD/JPY Teeters on Verge of Larger Breakdown

USD/JPY, Japanese Yen Talking Points:

• USD/JPY has shown some extreme volatility this week as it’s been multiple bounces between 145 support and 148 resistance.
• With U.S. inflation come in below expectations and potential for more U.S. rate cuts on the way, there could be additional motive for carry trades to unwind, and as we saw last year, that could be a de-leveraging event across global risk assets. The question now is whether bears can run with the breakdown in USD/JPY as there’s been a penchant for bear traps to brew in the pair.
• USD/JPY has brewed several bear traps over the past couple of months but with sellers making headway below 145.00, the big question now is whether a larger case of carry unwind shows up after this morning’s below-expected U.S. CPI print.

Last summer’s carry unwind in USD/JPY sparked after a below-expected CPI report from the U.S. brought along a higher probability of rate cuts from the Federal Reserve. It didn’t take long to impact equities as the carry trade that had driven for much of the prior four years unwound.

Some explanation is in order to describe how USD/JPY can bear impact to U.S. equities. As low Japanese rates offer cheap capital, American hedge funds and institutional investors can borrow from Japanese banks at low rates. The problem then is that they’re in essence long Yen as those loans are in JPY, and with Japanese rates remaining low while other economies lift rates, currency losses could impact any potential spread benefits. So, one way of addressing that risk is with a long USD/JPY trade, and that institution is now long USD and short-Yen to offset the currency risk from a Japanese bank loan. They can then invest that capital where they want with aim of pocketing the difference between whatever they can earn in the investment and the low Japanese rates that they signed up for.

This is something that could have benefit for all parties; for a Japanese economy that’s aging more and more and been saddled with a lack of growth and in some cases deflation, that additional capital will bring some investment into Japan; and a weaker Yen makes it easier to benefit from global trade as Japanese products are cheaper in foreign markets. It also makes it cheaper to incentivize tourism and travelers. For the banks taking the loan, well they get access to cheap capital.

When the carry trade is growing, it can be one of the most attractive economic backdrops to operate with, and for FX traders, it presents the opportunity for near daily rollover payments to go along with strong trends in the direction of the higher-yielding currencies.

In USD/JPY, this all started back in 2021, well before the Fed ever started hiking rates. Markets began pricing in the higher inflation in the U.S. in anticipation of eventual rate hikes and the pair began to trend higher even as the FOMC was saying that inflation was transitory.

As the Fed began to hike in March of 2022, USD/JPY went parabolic as now there was a higher rollover payment on the long side of the pair; and from an institutional perspective, there was now opportunity to borrow Yen and invest it in U.S. Treasuries and short-term paper simply looking to pocket the spread between the two.

While USD/JPY was trading sub-103 at the 2021 open, the pair quickly jumped to above 150 in 2022 as the Fed adjusted rates.

 

USD/JPY Monthly Price Chart

Chart prepared by James Stanley; data derived from Tradingview

 

Currencies Need Stability

 

Because currencies are the base of the financial system, stability is very much a preferred tenet. Because if people go to the store and see inflation jumping by 10 or 15%, that can lead to changes in consumer behavior that can then create ripple effects throughout the economy.

In Japan, it’s the Finance Ministry that’s in-charge of the currency and as the pair was pushing over the 150.00 level in 2022, they started to get concerned that consequences could follow. So they ordered the Bank of Japan to intervene in the market, buying JPY and selling USD with aim of stalling the trend.

The carry trade had become so incredibly one-sided at that point that a massive long position didn’t take long to pull back. The intervention itself pushed bulls back to the 145.00 handle, but what really caused the reversal was a below-expected CPI print in November of that year, bringing with it the prospect of change in U.S. monetary policy. And at that point, the ‘smoke in a crowded theater’ analogy began to play out as the pair retraced 50% of that prior trend in three short months after it had taken 21 months to build.

But – as we came into 2023, U.S. inflation remained high and Japanese inflation remained low – and the carry trade was now at an attractive support level. Buyers started to pile back in and price went right back to that 150.00 level.

Another glimpse of carry unwind showed in November of that year, once again on the back of a below-expected U.S. CPI report – but this time the retracement was just 23.6% of the prior rally, with support showing up ahead of the 2023 close and buyers coming back into the equation.

 

USD/JPY Weekly

Chart prepared by James Stanley; data derived from Tradingview

 

USD/JPY in 2024

 

In early-2024 trade U.S. inflation remained high and Japanese inflation low. In April, the 151.95 level that had been defended by the BoJ was under fire and bulls drove an aggressive breakout up to the 160.00 handle.

The Finance Ministry ordered more intervention but it couldn’t keep bulls at bay, as prices simply reverted back to the 160.00 handle as we moved into the second-half of the year. And then that’s when matters began to shift…

On July 11^th the Finance Ministry stood at the ready to order another intervention, and it was the same morning of a U.S. CPI release. Inflation came in below expectation that morning and, finally, it seemed as though FOMC rate cuts were coming into view.

The combination of unwinding of carry trades combined with BoJ intervention created an aggressive reversal, and soon other markets were showing pain.

Trades that were pushed by low Japanese rates were showing repercussion of the reversal and U.S. equities were getting hit hard in tandem with the USD/JPY unwind. This was global de-leveraging on the back of USD/JPY carry unwind, and by early-August, we had the 3^rd highest ever reading in the VIX index.

The USD/JPY sell-off started to stall as the 140.00 level came into play and there was just one day where that price level was traded through, and it was the Monday before the FOMC’s first rate cut of the cycle in September. And as USD reversed in Q4, USD/JPY shot back-up and in short order, many headlines were proclaiming that ‘the carry trade was back,’ which was somewhat of a dubious assertion given that rates in the U.S. were heading lower while inflation in Japan had shown higher readings.

As you can see from the above two charts, prices in USD/JPY remain well-elevated above levels that would historically be considered as ‘normal.’ And in my opinion, there’s still some carry trade left in here. But, as evidence mounts that U.S. markets may be seeing more rate cuts sooner rather than later, there’s even more incentive for those longer-term carry trades to close up. And if we see a similar repercussion as last year, that could lead to selling in related markets like U.S. equities.

I spoke of this in this week’s webinar and as I said then, this could be a repercussion from the tariff theme as President Trump had called out ‘currency manipulation and trade barriers’ as part of his tariffs levied on other countries. And while we’ve seen a pullback over the past couple days as a delay was announced, tariffs haven’t yet been called off. And that crowded room of longs in USD/JPY could be getting more and more jumpy as they see the weak-Yen policies that catapulted the pair higher, and in-turn, drove many other markets higher, come under fire.

On the short side of USD/JPY – there’s been multiple failed opportunities from sellers so far this year and quite a bit of that over the past week as 145.00 has come into the picture. There was a strong bounce yesterday as driven by the delay in tariffs – but the same resistance zone from Monday and Tuesday held the highs around 148 and that drove yet another reversal in the pair as volatility has continued to wind up in USD/JPY.

On a shorter-term basis, there’s lower-high resistance potential around the 147.00 handle. And the big question now is whether bears will push as price continues to hold near recently established 2025 lows.

 

USD/JPY Daily Price Chart

Chart prepared by James Stanley; data derived from Tradingview

--- written by James Stanley, Senior Strategist