Executive summary

While the yen strength has been the story of the last three months, which has impacted returns on all risky assets, that story may be changing. With the catalyst of monetary policy and a new BOJ governor, it may now be the time to express views using the options market.

The story for the last six months in FX may in fact be the story of USD/JPY. The weakening of the yen in the latter half of 2022 led to one official (and perhaps one unofficial) intervention by the BOJ. The concern was that the yield curve control policy (YCC) was becoming untenable. Even though the BOJ widened the band to 50 basis points from 25 basis points, there was still pressure. With that pressure, hit a crescendo in late October of 2022 and the yen began to strengthen. However, after trending lower for the last three months, there is reason to believe that could be changing based on USD/JPY holding support near 127 and now breaking above the downtrend over that period.

Image 1: Daily Ichimoku chart for USD/JPY

The peak in USD/JPY (bottom in the yen) also coincided with a bottoming in all risky assets. Perhaps this has to do with the role the yen plays as a funding currency for global hedge funds, that borrow in yen and use the proceeds to invest globally. In fact, if we look at the Macro Returns Index that Hedge Fund Research puts out, there is a relationship between the moves in USD/JPY and the returns of this index. As the yen strengthened, this would naturally lead to hedge funds looking to reduce risk. Given the short positions in many risk indexes at that time (based on the Commitment of Traders report), this could have helped catalyze the bounce in risky assets. With the yen strengthening materially the last three months, what does this suggest for the returns of macro accounts?

Image 2: USD/JPY vs. the HFRI Macro Return Index

There are some that will suggest this yen strength as a good deal to do with the interest rate differential between U.S. Treasuries and Japanese Government Bonds. As the spread widened in 2020-2021, U.S. dollar assets became more and more attractive to Japanese investors. In addition, the strengthening U.S. dollar would add to returns on an unhedged basis. However, with the Federal Reserve possibly getting close to ending rate hikes, the bond market pricing in cuts in the coming years, and the BOJ potentially considering relaxing YCC, this spread has narrowed, which has and should coincide with a weaker USD/JPY.

Image 3: U.S. Treasury less Japanese Government Bond (JGB) yields vs. the USD/JPY exchange rate

However, a more nuanced view of these relative changes in monetary policy may come by observing the M2 money supply growth in each country. I understand there is a stock vs. flow argument here, with the stock of money in the U.S. still at an all-time high. However, the flows of M2 growth have shifted remarkably. Monetary policy acts with a lag and so I have led the relative M2 growth by 14 months in the overlay vs. USD/JPY. If we compare the last 20 years, we may be given some idea of why the market has gotten relatively more bullish on the prospects of the yen in relation to the U.S. dollar.

Image 4: USD/JPY exchange rate compared to the difference in U.S. vs. Japan M2 growth

Another factor at play last year was inflation, particularly in the commodity prices. Yes, these prices affect the aforementioned monetary policy, however, there is also a more direct impact. As Japan is a net commodity importer, higher oil prices were a major drag on the economy in the last year. On the other hand, post the fracking revolution, the U.S. is a commodity exporter and so the dollar has become a sort of petrocurrency, benefitting from the increase in the oil price. We can see over the last several years, the move in the price of oil has also led the price of the USD/JPY exchange rate.

Image 5: USD/JPY exchange rate vs. Brent Crude

While the price of oil has moved lower over the past six months, with Russian supply making its way to markets and the U.S. releasing from the Strategic Petroleum Reserve, there is reason to think that this weakness is close to an end. China, another major commodity importer, is in the throes of reopening. I use the Li Keqiang Index for Chinese growth as it measures rail freight, electricity consumption, and lending. It also seems to lead the Brent Crude price and may suggest the bigger move lower in oil is finished. What could that mean for USD/JPY?

Image 6: Chinese Li Keqiang Index vs. Brent Crude price

Another factor that may point that we have seen the lows in the USD/JPY exchange rate is the performance of each economy. The blue line is the difference between the U.S. and Japanese economic surprise index. The white line is the difference in USD/JPY from its 200-day moving average. This suggests that the relative performance of each economy is not that different relative to expectations right now, whereas the yen is meaningfully stronger than the 200-day moving average. Has this stretched too far?

Image 7: U.S. vs. Japan economic surprises vs. USD/JPY exchange rate

We can see that levered accounts are currently at or near their least short of the Yen that we have seen over the last year. The rally for the past 3 months has coincided with leveraged accounts reducing Yen shorts. If there is a turn in the exchange rate, will leveraged accounts look to re-short the Yen?

Image 8: JPY net positions in Commitment of Traders report

Adding to the support for the dollar and pressure on the yen is that the weekly Ichimoku chart is into a support region while the MACD is poised to turn back higher and cross over. In addition, the RSI is turning back higher and the fact that it never got oversold suggest there may be a desire to get short yen (long dollar) in this area. For long-term accounts, this may be an attractive area to buy USD/JPY.

Image 9: Weekly Ichimoku USD/JPY chart

The narrative may be shifting for the pair as well. Looking at JPY/USD price, where the uptrend has broken and we are now targeting weaker Yen prices.

Image 10: JPY/USD daily candle chart

This change may not be reflected in the options market where we can see the difference between one month implied volatility and historical volatility is near the tightest spread over the last three months. A tight spread between implied and historical volatility suggests there is little risk premium being built into options prices for the coming month, which does include the next BOJ meeting.

Image 11: JPY/USD one month implied vs. historical volatility

We can see there is little expectation of volatility through early March. However, implied volatility for the expiration just past the March BOJ meeting moves back higher but then mean reverts into the April expiration and the BOJ meeting. Thus, there is some event volatility expected at that meeting, but nothing else meaningful feared in the near term.

Image 12: Term structure of JPY/USD implied volatility

In this chart, we look at the difference between UpVar and DownVar. We see that the skew for yen calls relative to yen puts is beginning to wane as well. Over the three months of rallies, we could see the higher demand for yen upside vs. downside. This is waning but there is still a premium for yen calls over puts, which is not indicative the market fears a move lower again in the yen.

Image 13: CVOL UpVar vs. DownVar skew vs. the Yen futures

Putting this together, we can see that while the trend toward a stronger yen has been noticeable in the past three months, and has potentially affected all risky assets, this trend may be coming to an end. It was based on the changing monetary policies and the impact on the interest rate differentials. However, we can see the currency pair has gotten stretched vs. the relative economic performance and the narrative may be changing right as we hit medium term support on the weekly charts. The yen is beginning to breakdown here, but this is not currently reflected in options prices, as the risk premium of implied vs. historical is narrow and there is still a skew toward yen calls over yen puts.

When I look at this circumstance, I am inclined to play a countertrend move toward a weaker yen. If the narrative is shifting and relative policy moves may not be as stark as before, leveraged accounts could well look to put yen short positions back on given these positions are quite small vs. the recent history. Macro funds have had much better returns in periods of yen weakness and so it may be inclined to find reasons to reinstate these shorts.

Using the skew in the market to our benefit, I look to the April expiration. While it expires a couple days before the April 8 date when Kuroda-san is meant to step down, it does capture the next BOJ meeting and comes at a lower implied volatility than the nearest expiration to that meeting. I have chosen to sell a yen call spread where the lower strike is struck at the resistance on the daily candle and the top strike to close the risk is struck above – a level where the thesis might be proven incorrect. I can earn enough premium in selling this call spread that I can buy 2 units of the .00725 yen puts, a level that is not even halfway of the move we have seen the last three months. It leads to a very attractive breakeven where my risk is capped, and I have unlimited potential upside.

Image 14: Expected Return

We can see that the options I am buying on the yen put are a full volatility point lower than the call I sell. The trade is initially short 0.45 deltas and long gamma, though the theta is relatively small at inception. This idea is initially more of a directional trade, however, if implied volatility moves higher coincident with yen weakness, we will be moving into a long gamma/long vega position as the yen weakens, which should provide favorable opportunities to trade if we don’t want to carry it until expiration.

Image 15: Greeks for a short yen call spread vs, long 2x yen put trade

The yen has been the story in FX for the last several months, into the fiscal year end, and during the change in BOJ governors – and it may continue to be. The narrative in the market may be shifting. We can see this in the technical charts, though not in the options market. This may provide us an attractive entry level to arrange a good reward to risk idea to take advantage.

Good luck trading!

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