The Japanese yen (JPY) appears to be locked into a classic vicious circle, aka. self-feeding trend or boom-bust cycle to the downside. In this issue, we will briefly examine the theory and process of a vicious circle; and present fundamental evidence a new rationale may be forming, which would likely lead to a significant correction or major change the trend. We will also look at the elliott wave pattern on USDJPY.
Quotable
“Nowhere is more nonsense talked than by currency experts about foreign exchange.”
–Winston Churchill
Theory
We look at two aspects of theory of a vicious circle for a currency:
1) Trilemma (Mundell-Fleming)
2) Reflexivity (Soros)
The Mundell-Fleming Trilemma says policy makers can control only two of the three main variables in global finance, but not all three at the same time.
“…it is not feasible to have at the same time a fixed exchange rate, full capital mobility and monetary policy independence. Only two of the three may co-exist (according to the Mundel-Fleming logic),” writes Helene Ray, of the London School of Business, International Channels of Transmission of Monetary Policy and the Mundellian Trilemma.
With almost all major central banks, and most importantly the de facto global central bank—the US Federal Reserve—becoming increasingly hawkish (with the market now expecting up to 350 basis points in hikes this year), Japan have chosen to take their monetary policy in the opposite direction. Thus, significantly widening the yield spread in favor of the US dollar as you can see in the chart below comparing the Japanese and US 2-year benchmark yield (red line) to the pair—JPY-USD (black line):
There is a tight positive correlation between the spread and the value of the yen. I.E., a fall in the spread (favoring deposits in the US over Japan) leads to a decline in the value of the yen. (Hot money seeking the highest total return, as discussed below.)
So, from a Trilemma perspective, Japan’s insistence on sovereign monetary policy (out of line with other G-7 players) and free capital flow has been very bad for the yen.
Reflexivity
Reflexivity as a theory for financial markets was first proposed by George Soros, in his book Alchemy of Finance, published 1987. (We share the short-version here.)
In essence, reflexivity is a common-sense idea. Effectively it says price equilibrium doesn’t not exist in the real world, because all market prices are flawed as they in turn are dependent upon participants expectations.
Reflexivity includes a pair of recursive functions (constituting a procedure that can repeat itself indefinitely):
1) The cognitive function – thinking
2) Participating function – acting
“On the one hand, participants seek to understand the situation in which they participate; on the other, their understanding serves as the basis of which influence the course of events. The two roles interfere with each other.”
Thus, decisions to “buy and sell are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions.”
The upshot: Players can’t be sure what is really moving currency prices—trade, interest rates, inflation, deficits, geopolitics, economic growth, on into infinitum. In the mind of those riding the trend in the right direction, all can represent valid rationales for the move. Thus, it emboldens those who are “right” to add to positions. This process becomes a feedback loop—or the raw material for a self-reinforcing trend.
Feedback loops, whereby the fundamentals can impact price and price in turn impacts fundamentals. This process is more powerful in currency markets than in the stock market precisely because it is more difficult to pinpoint the fundamental drivers for currencies (a host of potential macro factors), whereby there are real valuation gauges for stocks (earnings, cash flow, etc.).
And as it relates to currencies, the movement of the currency itself can become the most profitable component of the total return equation.
↑Expected Total Return = ↑Interest Yield + ↓Inflation + ↑Future Exchange Rate
This equation says the primary rationale for holding a particular currency is to maximize total return. That makes sense. Thus, expected total return will drive capital flow.
Capital flow is made up of two components: long-term portfolio flows or long-term capital investment in a country, and speculative capital flow—hot money sloshing back and forth across boarders seeking the highest return. Of the two flows, hot money has the greatest impact on currency prices within a speculators normal time frames.
And as said above, often the strongest component of return is the appreciation (if long) or depreciation (if short) in the currency itself. It can overwhelm the real yield component and why we often see currencies increasing in value relative to other currencies which offer a higher real yield. Thus, it is why self-reinforcing trends take on a life of their own relative real world fundamental and leads to overshoot-a drastic misalignment between value and price.
But trends do not form out of thin air. There is an underlying rationale for initiation of the trend. This leads us to the process of how trends are created, sustained, and eventually reversed.
Process
Here is a roadmap of a typical currency cycle*—the self-reinforcing trend—from extreme bearishness to extreme bullishness and back.
- Extreme bearishness—this is the stage where “shoe shine boys” are shorting the currency and can articulate the rationale to anyone and everyone who will listen. This is when things seem the most bearish, but are in reality most bullish (as later can be seen with the elusive gift of hindsight). This is Tao of the market time!
- Conversion flow—this is the stage when bears (during a long downtrend) start to question their “so obvious” rationale for being short. It is the stage where the flaw in perception of the crowd begins to be recognized by members of the crowd. Conversion flow has an early stage and a more advanced stage. It is why we see increased volatility when the trend changes. The players begin to realize something has changed. But they realize it at different times.
- Perception of the trend—this is the stage where the crowd recognizes that a new trend may be underway. They have discarded the old rationale and are beginning to accept the new one.
- Capitulation to the trend—now the trend is fully underway. The crotchety old diehard bears can’t hold out hope any longer—they capitulate and buy into the new trend. Often this is a sign that the new trend is actually becoming a bit stale, for now even the diehards are along for the ride.
- Extreme bullishness—now the “shoe shine boys” are buying the currency and are articulating the rationale to anyone and everyone who will listen. This is when things seem the most bullish, but are in reality most bearish.
*Source: John Percival, The Way of the Dollar
A pictorial representation of the process is below.
Though the rationales and drives may not be exact, a vicious circle in the yen can be seen as a virtuous circle for the US dollar. (You can see that many of the factors which can lead to a virtuous circle for the dollar are breaking done, albeit yield and safe haven still seem strong rationales; once these reverse, the dollar will likely be launched into a self-reinforcing downtrend.)
Evidence
Is there evidence the yen is in “overshoot” territory? Yes. When will the trend change? We do not know. This self-reinforcing process can run as long as new money is thrown at the trend. But we could be getting close…
Purchasing Power Parity (or the Economist Big Mac Index), is a long-term measure of fundamental value. According to the Big Mac Index from the end of December 2021, the yen was 42% undervalued against the US dollar—when the yen stood at 115. Now the yen is at 130—even more undervalued. For a G-7 currency, this represents an extreme undervaluation.
Though deficits are often used as reasons for a movement in the currency; it is not a trading tool. But as a longer-term measure it can often suggest a change in trend is overdue when a country’s currency and current account are diverging. Interestingly, in the two charts below there is divergence in the currency and current account for both the US and Japan.
US Current Account Deficit vs. US Dollar Index
As you can see, the US current account deficit (gold line) is growing rapidly (surging into all-time high territory), while the US dollar (purple line) is rising—quite a divergence is developing in these price series.
Japan Current Account Deficit vs. Japanese yen-USD
As you can see, the Japanese current account balance (gold line) is improving, while the value of Japanese yen-US (purple line) has falling. Again, quite a divergence here also.
There is growing evidence the United States if heading for a recession. Here are some of the factors to support that view from Hoisington Research:
1) the largest twelve month decline in real weekly earnings of 3.3% since this series began in 2000 which covers 72 million people.
2) Real per capita disposable income now stands 1.8% below one year ago levels and has fallen for seven consecutive months.
3) The composite index of the NFIB Small Business Survey sank to 93.2 in March the lowest since April of 2020.
4) Interest rate sensitive sectors such as housing and autos are already declining.
5) Inventories are rising rapidly and will accelerate further with any softness in demand causing cutbacks in production.
6) Fiscal policy turns restrictive in 2022 and there is just a hint of early restraint in Fed policy as total reserves declined by $425 billion since December and the main component of M2, other checkable deposits, has shown just 3.7% growth over the last three months.
This suggests we may be near peak inflation in the US. If so, that, and a recession, would change the expectations for interest rates quickly.
Whereas there is growing evidence rising inflation is hurting the consumer and businesses who rely heavily on imports in Japan. A growing chorus of analysts believe this will force the Bank of Japan to change course and raise interest rates; that would make the yen look more attractive on a yield basis compared to US dollar.
However, the counter argument is still strong—a weak yen is good for Japanese business as seen in Japan’s rising current account balance. But the benefits created by a weak yen, may be the seed corn for a strong yen.
From Leo Lewis of the Financial Times:
“Japan’s increasingly important ‘not China’ status in a less certain and deglobalising world. Where previously the focus of Tokyo bankers and lawyers had been on the outbound dealmaking of corporate Japan, they now report a striking switch. As global industry begins to re-engineer itself away from efficiency and towards security, Japan’s position as a reliable partner, manufacturing hub or supply chain link for US and European businesses has been significantly enhanced. The weak yen, say the bankers, is already tipping investment decisions in favour of Japan, with that trend likely to accelerate.”
This could significantly increase demand for yen.
Additionally, Japanese investors hold a lot of US Treasuries—estimated at around $1.3 trillion dollars. Treasury prices are falling fast and there is anecdotal evidence some Japanese players are dumping US bonds. Though relatively small compared to total holdings, $60 billion of Treasuries have been dumped in the last three months. But it could be just the beginning. It is the “at the margin” stuff that is important in financial markets.
Looking at the Weekly Commitment of Traders report for Japanese yen currency futures, you can see that negative positioning is approaching a four-year bearish extreme. Based on our conversion flow measure, we would expect to see a significant decrease in negative open interest to indicate a correction may be in the works.
CFTC JPY speculative net positions
Here is a look at our current wave view on the yen. We have a target near 135 USD/JPY for completion of a major Wave III. Setting the stage for a significant and multi-week playable correction.
Stay tuned.
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