USDJPY spike sparks talk of regime shift in the yen

The yen, which had been under pressure ahead of the announcement, dropped further as Tokyo revealed a 2011 trade deficit of ¥2.5 trillion. USDJPY, which had been stuck around the ¥77.00 level for most of January, traded up to a high of ¥78.13, threatening to break out of the ¥76.30-¥78.30 range that has held since early November.

In the options market, USDJPY vols traded higher across the board, with particular demand seen for short-dated topside strikes.

The USDJPY risk-reversal curve is now pricing dollar calls over puts up to the three-month expiry, with one-month risk reversals trading at 0.7 and three-month risk reversals trading at 0.2.

“The market is therefore expecting that a yen weakening is likely to be more volatile than an appreciation,” says Olivier Korber at Société Générale.

He said this pattern was quite atypical as the three-month skew had never traded in positive territory before.

“It is premature to call for a new regime in USDJPY vols but we will closely monitor this new configuration,” adds Korber.

The deficit was not unexpected, however, and reflected the need for Japan to step up its energy imports after last year’s nuclear accident, and the resulting negative impact of factory shutdowns on its exports of cars and electronic goods. “Even so, it highlights the risk that in the next few years Japan is set to confront a worsening in fundamentals,” says Jane Foley, currency strategist at Rabobank.

She said forecasts were emerging that Japan could lose its creditor status perhaps as soon as 2015, while the country’s ageing population had been eating into household savings rates for years and would increase the fiscal burden too.

This is worrying news for Japan, which is the world’s most indebted nation, with a gross debt of 200% of GDP.

“The risk is that, at some point in the next decade, JGB yields will spike higher and the yen will drop as its safe-haven appeal is loosened,” says Foley. “The difficulty is identifying the trigger for this event.”

Most agree that moment is not upon us, however.

Indeed, the main driving force of the current bout of yen weakness appears to be improving risk appetite sparked by the European Central Bank’s move to ease liquidity conditions in the banking sector.

That has seen haven demand for the yen fall and prompted investors to cut back long positions in the currency, which according to data from the Chicago Mercantile Exchange now sit close to record levels.

Lee Hardman, currency economist at Bank of Tokyo-Mitsubishi UFJ, said near-term yen weakness accelerated after USDJPY’s break above resistance around ¥77.50 on Tuesday, which represented a long-term downward trend line, joining intra-day highs from June 2007, May 2010 and April 2011.

“The technical break has likely triggered some short-term position adjustment among speculative investors who have been caught holding elevated long positions,” he says.

“The main driver of yen strength during the second half of 2011 was safe-haven demand for short-term Japanese money market securities, which is likely easing now that risk sentiment is improving.”

However, Hardman believes the current weakness in the yen is more likely to be corrective than a trend reversal.

He notes that although Japan recorded a trade deficit in 2011, it still ran a sizeable and stable investment income surplus totalling close to ¥15.0 trillion in the 12 months to November 2011 and its current account balance has remained firmly in surplus.

“The Fed’s commitment to maintain low rates will help cap USDJPY upside potential,” says Hardman.