The USD/JPY still isn’t backing up the rally, should we worry?

The U.S stock indices continued to climb higher last week, reaching new highs. Even though many investor’s on Wall Street are now calling for a major pullback, after this 7 month rally, the U.S indices continued to climb higher, prevailing against all odds. Last week’s trading week was backed by economic data, as further sectors in the U.S showed an improving situation. Retail sales jumped by 2.7%, compared to an expected 2% increase, while inflation data showed a mild situation. The CPI m/m came out just over expectations, while the y/y figure came out better than expected at -1.5%. When taking a glance at the chart below one can see that despite all the thoughts, last week’s trading week was characterized by increasing volume on all the major indices. When observing the leading technology sector, one can see that the index broke its major resistance level (200 weekly moving average), characterized by inclining volume.
 


To date officials opinions have changed regarding the economic outlook and many banks are now analyzing exit strategies, to reduce the government’s influences in the markets. The ongoing positive data along with comments from officials are now having extreme pressure on the Green back, as investors are rushing back into riskier assets. When observing the various currency pairs such as the AUD/USD and the EUR/USD together with the current stock rally, one can see that similar to the previous cycle, these assets are showing a strong correlation, climbing higher on expectations of a brighter future.

So where is the problem?

When analyzing the charts one can see that the lowest yielding currency, the Japanese Yen, yielding a mere 0.1%, is rally against the U.S Dollar, due to overall Dollar weakness. This type of situation is confusing certain investors, as current expectations of future rate hikes in the U.S aren’t yet providing Dollar strength. Even though the chart has reached a critical support level which could lead to a bounce, the recent two month rally has been characterized by more short positions on this pair, than long position. 
 

A Walk down history Lane

After World War II most of Japan's economy was demolished, millions of citizens were jobless and the government's main aim was to rebuild the economy back up from scratch. For years to come, Japan's economy based itself on manufacturing, services, shipping, machine tools and exporting motor vehicles which seemed to be the economies main source of income. The irony is, that those same countries that demolished Japan's economy, such as the U.S, helped reestablish it by becoming their prime consumers through exports.

Even though Japan's economy faced many obstacles along the way: other growing economies that based their incomes on those same goods and rising oil prices that had peaked twice during the 70's and 80's, japans economy managed to stay afloat because of cheap labor and competitive costs.

In 1979 Japan entered a new field, production of semiconductor chips along with technology. Not knowing that the outcomes of this new era would lead to catastrophic results for years to come, the economy entered a period of rapid growth which affected it in two ways:
 

1. Rapid growth led Japan to be the second leading economy market in the world after the U.S
2. Mass uncontrolled growth led the markets into a bubble, waiting to be burst. Prices were extremely high and the stock market at that time had money flowing into it making stocks well over priced.

Carry trades

While Japanese companies were struggling, foreign companies were galloping forward as their economies expanded at a rapid pace. As global economies and major indices raced forward forcing central banks to raise their interest rates (to control inflation), the difference in interest rates between Japan’s rate of 0.5% and other economies high rates presented investors with excellent investing opportunities. It is a well know fact that hedge funds and large firms yield on average 11% per year. If that is the case, carry trades (selling a low yielding currency and buying a high yielding currency) presented those investors with excellent returns. At the peak of economic growth, last year, the New-Zealand Dollar was yielding 7.5%. Selling the Japanese Yen currency, or taking a loan from Japan at 0.5% and investing it in the New-Zealand Dollar, yielded on average a 7% yearly return (only if the New-Zealand Dollar would gain value over the years - which it did).

When observing the USD/JPY chart one can see that a similar situation occurred but only at a later stage during the cycle. Yet again investor’s used the difference in interest to their advantage, driving the U.S Dollar higher, but only once the U.S economy was at a full recovery. One can see that during 2003-2004 the USD/JPY continued to show weakness, as other currencies showed strength against low yielding ones.

Today’s Situation

Even though we are now witnessing a similar situation to the previous recession, one must note that the state of the Dollar this time round is far worse. Countries are now diversifying their portfolios preferring other counties’ government bonds, than the U.S’s. This situation has also occurred due to the recent stimulus, forcing the U.S to run up an enormous deficit- something that it is weighing on investor’s confidence, and further hurting the Greenback. When looking forward, one could expect the USD/JPY to react at a later stage, during the recovery, but with today’s situation and investor’s lack of confidence in the USD, could the USD/JPY fail to recover? Furthermore could the USD turn into the next carry trade?