Markets in focus
The US dollar’s recent break of the 100 mark turned out to be short-lived, as it promptly bounced above the support and back into the descending triangle.
When observed over an extended timeframe, the US dollar displays significant cyclical behavior, with most pivotal turning points occurring at approximately 3.5-year intervals.
CHF/USD has broken out from a ten-year rectangle pattern. If the breakout is confirmed, it bears significant implications from a technical analysis standpoint.
The overhead resistance for JPY/USD is somewhere between 0.0072 and 0.0073 (roughly equivalent to 138 to 139 in USD/JPY terms). Breaching this level, the Yen has the potential to strengthen further to 126 – 127 against the dollar.
EUR/JPY currently sits at the upper resistance of a symmetrical triangle that has been in formation for nearly three decades. A strengthening Yen will likely prompt a pullback of this pair towards the midpoint of the range, approximately at the 130 mark.
Our market views
Last week, the Federal Reserve’s (Fed) expected 25bps rate hike seemed to have dominated the news headlines, but the Bank of Japan (BoJ) quietly took the global financial stage with a surprising policy shift. In the US, even though Chairman Powell subtly hinted at one more potential hike in September, the market and the Fed Dot Plot seem to concur that the end of this rate hiking cycle is in sight, if not already upon us. The BoJ, usually the most dovish among all major central banks, surprised markets by tweaking its long-standing Yield Curve Control (YCC) policy, hinting at the first steps towards normalization of Japan’s yield curve under the new leadership of Governor Kazuo Ueda.
This divergence in monetary policies across the globe, as nations navigate distinct phases of their economic cycles, makes the foreign exchange market an exciting playing field. As shown in Figure 2 above, the US dollar exhibits a strong cyclicality since the 90s, with major turning points (usually local bottoms) roughly every 3.5 years. From this, we anticipate another low in 2024 as the Fed likely pivots its attention from inflation to potential economic downturns. However, the forex market is fundamentally a relative performance trade between two currencies, which inevitably leads us to the question - against which currency should we compare the dollar?
Considering the recent BoJ meeting, the Japanese Yen presents a compelling case. Even though the BoJ kept the benchmark interest rate unchanged, its new, more flexible approach to managing its YCC policy has sparked significant market interest. This shift towards more flexible management of the yield curve might be a subtle indication of the BoJ moving away from its aggressive stimulus program.
It’s worth noting that this newfound flexibility does not equate to an immediate end to the low-interest-rate era in Japan. It’s a shift from a perpetual low-rate environment to a scenario where higher rates are now possible. Easy money will continue for the foreseeable future, but the door is now open to potentially higher Japanese rates. This shift is a crucial change in market dynamics, making the Yen less attractive as a historically favored funding currency. Consider Figure 3 a sneak peek of the potential impact of a carry trade unwind in the face of diverging monetary policies. The Swiss Franc, another popular funding currency, has arguably made a remarkable breakout from a three-decade range against the dollar, as the Swiss National Bank signals a willingness for further rate hikes.
What’s more? Major Yen crosses like EUR/JPY and AUD/JPY teeter on the edge of critical inflection points with multi-decade significance, suggesting Yen will likely outperform many other major currencies, not just the US dollar. We believe Yen’s strengthening is still in the nascent stage, making the risk-to-reward proposition of a bullish stance of Yen increasingly enticing.
How do we express our views?
We consider expressing our views via the following hypothetical trades1:
Case study 1: long JPY/USD future
We would consider taking a long position on the JPY/USD future (6JU3) at the present level of 0.0072, with a stop-loss below 0.00697, which could bring us a hypothetical maximum loss of 0.00023 points. Looking at Figure 4, if JPY starts to strengthen and breaks above 0.0074 level, it has the potential to reach 0.0078, a hypothetical gain of 0.0006 points. A JPY/USD future contract represents 12,500,000 Japanese Yen; each point move is USD 12,500,000.
Case study 2: long CHF/USD future
We would consider taking a long position on the CHF/USD future (6SU3) at the present level of 1.157, with a stop-loss below 1.117, which could bring us a hypothetical maximum loss of 0.04 points. Looking at Figure 3, if the breakout is confirmed and the up move continues, CHF/USD has the potential to reach back to 1.27, a hypothetical gain of 0.113 points. A CHF/USD future contract represents 125,000 Swiss Francs; each point move is USD 125,000.
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EXAMPLES CITED ABOVE ARE FOR ILLUSTRATION ONLY AND SHALL NOT BE CONSTRUED AS INVESTMENT RECOMMENDATIONS OR ADVICE. THEY SERVE AS AN INTEGRAL PART OF A CASE STUDY TO DEMONSTRATE FUNDAMENTAL CONCEPTS IN RISK MANAGEMENT UNDER GIVEN MARKET SCENARIOS. PLEASE REFER TO FULL DISCLAIMERS AT THE END OF THE COMMENTARY.