I didn’t get around to writing up my note yesterday, because I was thinking about JPY. I have copied my note to my colleagues below.

I lost money earlier in the month shorting USD/JPY. I thought that the 2-year interest rate spread, with which the currency pair is highly correlated, would not widen because I expected US rates to remain low. This was muddled thinking: US rates do remain low, but they have nonetheless moved enough to move the currency.

Now the interest rate spread has rolled over and the currency has done so as well. What is more, having been positively correlated with risk assets for the past month or two, JPY appears to be resuming its risk-of characteristic. This is consistent with my view that the crucial opposition in markets at present is between risk-on/risk-off and risk decoupling. Bernanke’s doveish comments in the past week have, at least in the short term, raised the probability of further Fed action – which is what creates risk-on/risk-off. A positive correlation between JPY and risk assets was a risk-decoupling phenomenon; with risk-on/risk-off returning, JPY should resume its correlation with the two-year interest-rate spread.

JPY’s recent weakness was kicked off, of course, by the BoJ’s announcement of an inflation “goal” and a large round of asset purchases. This caused Japanese equities and the currency to rise even faster than the global equity rally would have led us to expect. Similarly, it caused JPY to fall further than the move in the 2-year spread alone would have implied (from the white diamond on the chart below at the start of February to the red star today).

Japan-US 2-year Spread vs. USD/JPY

An important question is whether the change in Japanese monetary policy is likely to move the currency so far from its historical relationship with the interest-rate spread that the market will move outside the scatter plot in the chart. In order to answer this question, we have to think about what has changed in Japan. The key thing is that a chink has appeared in the BoJ’s armour. It no longer appears able to avoid acting to put an end to Japan’s persistent deflation, on account of a combination of political pressure and international pressure (in the form of the Fed’s introduction of an inflation target). That should have a positive effect on economic expectations, and indeed Japanese 7-year breakeven inflation has recently moved above 0% for the first time since 2008. Rising inflation expectations are a good sign in a liquidity trap. To the extent that this action improves Japan’s economic prospects and thereby brings forward the date of any eventual interest-rate increase, this should be positive for the currency – i.e. USD/JPY should fall.
One might argue that USD/JPY should rise on the basis that asset purchases are a signal to banks that it is safe to engage in carry trades, because interest rates will not rise while they are going on; but it was not likely that interest rates would be increased in the next few years in any case if no action had been taken against deflation, so I cannot see that JPY has suddenly become attractive as a funding currency on that basis.

Perhaps USD/JPY should rise because the BoJ, by increasing inflation expectations, has removed the fear that the JPY will appreciate indefinitely – funding currencies are not attractive if they are expected to go up (a country that experiences persistent deflation should expect to see its currency appreciate, other things being equal). But this is simply an argument that it is the real interest-rate spread, not the nominal spread, that matters for the currency. We can test this proposition. Japan, unfortunately, has no 2-year linkers at present, but it has 5-year ones to we can compare the correlation of the currency to 5-year real and nominal spreads.

Japan-US 5-year Spread vs. USD/JPY

Japan-US 5-year Real Spread vs. USD/JPY

As you can see, USD/JPY is clearly related much more strongly to the nominal 5-year interest-rate spread than the 5-year real interest rate spread.

I cannot see any good reason, therefore, why JPY should break its historical relationship with the 2-year interest-rate spread on account of the BoJ’s recent action. Thus important question becomes: what is going to happen to the 2-year interest-rate spread? 2-year rates have not appreciated to their levels of late 2010 to early 2011 – the last time economic optimism was rising – and this tells us something interesting. It tells us that the Fed’s new communication strategy has been more effective than QE at keeping interest-rates low. Ben Bernanke had only to sound doveish this week to bring the 2-year spread back down to 35bps from a recent high of 40bps. It is unfortunate that the Fed’s communication strategy is not clearer – it frames the idea that rates will be low until at least late 2014 as an expectation rather than a commitment, for example – because it means we have no basis for calculating a maximum reasonable level for 2-year rates. What we do have to bet on, however, is the evidence of this latest episode of rising rates. An expectation that the economy was strong enough that the Fed would not do QE3 brought rates up to 40bps; a little doveishness on the part of the Fed chairman brought them back to 35bps. Logically, therefore, the economic picture would have to improve quite a lot from here for rates to increase above 40bps.

I feel that I may be developing the basis for a trade: short USD/JPY. I got into this trade too early, in February, but that is not a reason to reject it now. The fact that the market is presently on the outside edge of the scatter plot gives me some protection on the downside, and so does the fact that the market should not move against me if the US economy continues to improve at its present rate or slows from here – this seems a more reasonable bet than that the expansion will accelerate beyond the market’s expectations, given the tendency of economic data to disappoint at this time of year and the general optimism that prevails at present.