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Foreign Exchange

Dollar-yen will grind lower – catch it with a seagull

The decreasing likelihood of currency intervention by the Bank of Japan, coupled with the gloomy outlook for US economy, should see the USD/JPY continue to grind lower, say analysts.

This flies in the face of protestations from Japanese authorities who are concerned about the yen’s appreciation.

However, analysts at Citi argue the BoJ’s hands are tied and coordinated intervention is also unlikely, following the Bank of Japan’s foray into the markets on August 4, because of upcoming events such as the Japanese presidential elections, a central bank meeting and a G7 summit in September.

Rather, given the weak outlook for the US economy and the dynamics of the yen in a weak macro/deleveraging environment, continued appreciation of the Japanese currency is likely, says Paul Meggyesi, a currency strategist at JPMorgan in London. He cautions that it is unlikely to be a dramatic rise.

Meggyesi says: “Our view is that this is not an environment in which the dollar is going to rally. Although the dollar may regain some broad strength due to de-risking of markets more generally, the yen will likely grind its way higher, as it traditionally has done in this situation. Further compression of US-Japan interest rate spreads also gives a fairly clear direction in dollar-yen.”

To implement a strategy based on this view, Meggyesi says investors can effectively use seagull option strategies, which allow them to capture the gradual appreciation of the yen and the limited prospect of USD/JPY trading back above 80.00. By selling top side USD calls and buying a USD put spread, investors can cheapen up the structure.

“We have a limited downside target for USD/JPY and doubt it will fall in an abrupt fashion, therefore we don’t want to be long vega,” says Meggyesi. “We see little risk of USD/JPY rallying in this environment, hence we are subsidising the cost of buying the put spread in USD/JPY by simultaneously selling a call at a higher strike.”

Yen-denominated option volatility plays are probably a better bet than most other currency pairs when there are volatile and deleveraging markets because they have remained relatively stable even in the face of high vol sell offs in risk markets.

For instance, six-month implied vols are currently trading at 12.2%, even as the S&P500 lost 16% and the VIX almost trebled between late July and early August, hitting 48 on August 8. Realised volatility in dollar-yen over this period has not even come close to matching implied vols.

“It begs the question that if large swings in stocks and a tripling of equity vols isn’t sufficient to bring realised vol above implied vol then what is?” asks Meggyesi. “Probably not much, which suggests implied vols will stay pretty rich relative to what realised vols are doing.”

On August 1 JPM’s analysts put on a seagull structure based on a spot rate of 77.20, where they bought a USD put with a strike price of 77.26 and sold a USD put with a strike of 72.80, which was financed by selling a USD call with a strike of 81.73. At the time, the structure cost 0.65%; it is now valued at 1.33%, according to Meggyesi.

However in a short term basis, traders say there is a demand for shorted dated topside in USD/JPY, looking for the intervention play from the BoJ. “1 week risk reversals are now at 1.2 for USD calls and though 3 month is a bit softer, it remains at 2 vols for JPY calls (r/r bid for USD calls out to 2w)” a UK-based options trader tells EuromoneyFXNews.

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