The USD/JPY exchange rate has suffered a remarkable reversal in the past few weeks as the Federal Reserve and Bank of Japan (BoJ) divergence continues. It has dropped for four consecutive weeks and reached a low of 149.54, down from the year-to-date high of 161.76.
Hedge funds caught off-guard
The ongoing USD/JPY pair has hurt hedge funds and other speculators who continue to be short the Japanese yen. Data by the Commodity Futures Trading Commission (CFTC) shows that speculators have held a net short position on the yen since March 2021.
Of course, these investors have made a fortune as the Japanese yen has plunged by over 47% from its highest level in 2020. Now, some of these investors are closing their positions as the currency rebounds. The net short positioning has dropped from minus 184,000 in June to 107,000 last week.
Dovish Federal Reserve
The USD/JPY has retreated primarily because of the ongoing divergence between the Federal Reserve and the Bank of Japan (BoJ).
In its interest rate decision on Wednesday, the bank decided to leave interest rates unchanged between 5.25% and 5.50%. That decision did not catch investors off-guard since it was in line with what analysts were expecting.
In its statement, the bank noted that it was now focused on both sides of the dual-mandate: labour market and inflation.
Recent data showed that these numbers were moving in different directions. Inflation is moving towards the Federal Reserve target of 2.0% since it has dropped for three straight months.
On the other hand, the unemployment rate has continued softening in the past few months. Data released on Wednesday by ADP showed that the private sector added just 122,000 jobs in July, the smallest increase in over a year.
A day earlier, data by the Bureau of Labor Statistics (BLS) revealed that the number of vacancies in the US fell to a two-year low.
Economists expect that Friday’s non-farm payrolls (NFP) data will show that the economy added 140,000 jobs while the unemployment rate rose to 4.2%.
Therefore, if these numbers are correct, and if inflation softened in July, the Fed will use its Jackson Hole Symposium to point to a rate cut in September. If this happens, it means that the US dollar will be softer for a while.
Bank of Japan rate hike
The Fed and the BoJ are, therefore, moving in the opposite direction. In its interest rate decision on Wednesday, the bank decided to deliver its second its second hike in 17 years.
It hiked interest rates by 0.25%, a few months after it increased them by 0.10%. Most importantly, the bank signaled that it might continue hiking in the coming months if inflation remains steady.
The BoJ’s rate hikes come after the central bank made major forex interventions worth over $22 billion as the yen collapsed.
However, the BoJ risks causing a major downturn in an economy that is already showing signs of slowing down. Data by Au Jibun Bank showed that the country’s manufacturing PMI dropped from 50 in June to 49.1 in July. That drop was lower than the median estimate of 49.2. It came two days after Japan published weak industrial production data.
At the same time, the USD/JPY performance is a sign that investors are unwinding the most popular carry trade in the market. A carry trade is a situation where investors borrow a cheaper currency than the JPY and invest in a higher-yielding one.
For a long time, the USD to JPY pair has been one of the best carry trade pair because of the widening spread between the two interest rates. Now, with the two banks moving in the opposite direction, there are signs that investors will start to unwind their trades. In a note, ING analysts said:
“Yet the carry trade unwind of July has caused carnage for the activity currencies and perhaps some unfinished business in the USD/JPY correction may discourage investors from returning to activity currencies just yet.”
USD/JPY forecast
USD/JPY chart by TradingView
The USD/JPY pair is at risk of a deeper downturn as the USD to Kenya shilling did this year. Interestingly, this crash is in line with what I predicted a few months ago, citing the rising wedge chart pattern that has been forming since December.
The USD to JPY pair has retreated below the 50-week moving average. It has moved below the 50-week moving average while the Relative Strength Index (RSI) has moved below the neutral point at 50.
Therefore, the pair will likely continue falling as sellers target the key support at 145. On the flip side, a move above the key resistance point at 151.91 will invalidate the bearish view.
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