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October 27, 2016

Japanese Yen Is A Bond Play

By Lior Alkalay,  INO.com

The Japanese Yen is finally ready for another bearish wave, the kind that could drive the Dollar-Yen trade to retest the 2015 highs. At least, that is what the USD/JPY technical analysis suggests. According to the MACD Index, the selling momentum has weakened, and the pair is just resting above the 100 pivot, a key pivot for the pair. But the question is, are fundamentals ripe for another Yen selloff and a USD/JPY rally?

MarketClub Weekly Chart of USD/JPY




Yen is a Bond Play

As I often reiterate, the Japanese Yen is essentially a bond play. Over the past decade, Japan has been stuck in a long deflationary cycle of falling prices and less than 1% average growth in five years. Moreover, Japanese consumers, as well as Japanese corporations, have had an overwhelming desire to hoard mountains of cash which only exacerbates the stagnation of the Japanese economy. The combination of constant cash hoarding and deflation has created a very robust market for Japanese Government Bonds. The Japanese government has tried to balance the phenomenon by accumulating a jaw-dropping debt of 229% of GDP or roughly $9.5 Trillion, and by trying to spur growth. Instead of balance, however, it has made the Japanese Government Bond market so overwhelmingly large (compared to other sectors), that it essentially dominates the dynamics of the Yen. When demand for Japanese Government Bond rises so does demand for the Yen, and vice versa.

This dynamic may change from time to time, as when Shinzo Abe, the Japanese Prime Minister, was first elected and when he announced his economic scheme known the world over as Abenomics. The dynamic also changed when the Bank of Japan initiated an aggressive Quantitative Easing program of ¥80 Trillion buying bonds, notes, and even ETFs in order to spur growth. But as Japan’s latest inflation data reveals, deflation has returned. Japan’s CPI (Consumer Price Index) fell by 0.5% Year over Year reading below zero for the sixth consecutive month, shattering hopes for recovery and bringing back the Yen as a proxy for bond demand.

Demand for Bonds and the Yen

So, what drives demand for Japanese Government Bonds? Inevitably, it is global sentiment towards bonds or the so-called risk on/risk off trade. When investors flee to safety, they park their cash in safe haven assets such as notes and bonds of the Japanese government. Hence, in order to gauge sentiment for Japanese government notes and bonds which, of course, will lead us to gauge the Yen, we must gauge global sentiment for bonds.

MarketClub Chart of iShares 7-10 Year Treasury Bond (PACF:IEF)



In order to examine the various aspects of the global bond market, we can use Bond ETFs as a proxy. Among them, we can consider the iShares 7-10 Year Treasury Bond (PACF:IEF) ETF, which has an effective duration of 7.62 years (a duration of 7-10 years is the most relevant in this case) as well as those that have the highest impact on mortgage rates. The second ETF we will use is the Vanguard Total International Bond ETF (NASDAQ:BNDX) (see below). The BNDX tracks global bonds (except US bonds) with an underweight to emerging markets (to more accurately reflect the aversion from risk). The BNDX has an effective duration of 8 years. Analyzing the trends of both ETFs will shed light on the latest trends in global bonds and hence shed light on your Yen analysis.

As we can see by examining both the IEF and the BNDX fund price, an interesting picture emerges. Both are facing either resistance or outflows and weaker volumes. This suggests a correction in price, which further suggests that bonds are facing a correction. But there is one big caveat; notice that the long-term bullish trend for either ETF hasn’t yet been broken.

MarketClub Chart of Vanguard Total International Bond ETF (NASDAQ:BNDX)



The conclusion we can draw from this is that, yes, bonds face a correction. In turn, that could mean Japanese Government Bonds could face a similar selloff and push the Yen lower, which would allow the USD/JPY to surge and retest the 110 level. But, for those who are counting on the USD/JPY moving any higher with another wave of selloffs, one must be prudent and prepare for another leg down in the pair when bonds bounce back. And then, perhaps, once bonds have topped out, we can finally get another massive bullish wave from the USD/JPY into the 125 high.

Courtesy of Lior Alkalay,  INO.com

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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