On Monday I wrote:

“I have been thinking about shorting USD/JPY. The market has run up sharply in the past couple of weeks, with the news outlets reporting the reason as being the BoJ’s new “inflation target”. I am not sure that this is a good reason for the market to move, nor that it is the reason the market has moved. On the former point, Mr. Shirakawa is known to be an opponent of inflation targeting and, in a recent speech, has reaffirmed his belief that the BoJ cannot end Japan’s deflation alone (he thinks the government needs to “strengthen Japan’s growth potential and growth expectations”). So it is unlikely that the “target” (“goal” is a better translation) will lead the BoJ to take the kind of aggressive action actually that might actually lead to a 1% inflation rate.

On the latter point, other factors have been in play. The main determinant of the level of USD/JPY is the spread between Japanese and US interest rates (I have used 2-year rates). Historical correlations between the two series are high over various time frames. Recent strong data in the US have caused US 2-year rates to increase a little, and Japanese 2-year rates have recently fallen a little, and hence the spread has widened fairly sharply. The latest data point is on the outside edge of a scatter plot but far from being an outlier. So the move in the 2-year spread would seem to be the basis of any explanation. USD/JPY has moved more than the change in the spread would imply, however. The explanation may be the 1% goal, but I think it is more likely the BoJ’s other recent action — the increase in its asset purchases. A monetary loosening would be consistent with a move across the scatter plot to the outer edge.

I am wondering whether I should be short USD/JPY, but I am wary of entering at current levels. Currencies are spiky and USD/JPY especially so; a relatively narrow stop could easily be taken out. At present, my stop would be around the centre of the range that the market created between October 2010 and July 2011, and it strikes me that it could easily get back there if US rates or FX market players were to get a bit ahead of themselves (I expect 2-year rates to remain generally low, but that does not preclude short-term moves). I would prefer to have a stock at a more obviously wrong level — say, towards the top of the 2010-11 range. So I am inclined to wait.”

The market has risen a little since Monday, allowing for a wider stop, and the run upwards in USD rates has halted, which makes me less worried about fighting a strong rally. I think that USD 2-year rates are likely to remain low for the foreseeable future. Further, if the BoJ actually does act in a credible way to increase inflation, then 2-year rates should increase; if it does not, then they do not have much further to fall. Thus the spread between USD and JPY 2-year rates is unlikely to increase. Without the impetus from an increase in this spread, I expect USD/JPY to remain in its low range; it does not have to fall far, relative to recent history, for me to make a good profit.