FXY - FXY: Dovish BOJ Could Signal FXY Weakness
2023-05-02 09:45:40 ET
Summary
- The FXY Trust holds Japanese Yen. It is a direct bet on USDJPY exchange rate.
- Incoming BOJ governor signalled a continuation of ultra-dovish policies and a 1.5-year review process. This suggests status quo on Japanese monetary policy.
- Given interest rate differentials have actually gotten much wider since October, it is possible for the Yen to weaken to October levels and beyond with the BOJ's laissez-faire attitude.
- I believe now is a good time to short the FXY trust.
The Invesco CurrencyShares Japanese Yen Trust ( FXY ) holds Japanese Yen in trust. It is a direct bet on the Yen against the U.S. dollar.
With the incoming BOJ governor continuing with his predecessor's ultra-dovish policies, the Yen risks re-testing 2022 levels as interest rate differentials have gotten even wider. I believe now is a good risk/reward level to short the FXY ETF, playing on the indecisiveness of the incoming BOJ governor.
Fund Overview
The Invesco CurrencyShares Japanese Yen Trust tracks the price of the Japanese Yen against the U.S. Dollar ("USD"). The trust holds Japanese Yen and appreciates in value when the Yen appreciates in value against the USD.
The FXY ETF is a convenient way for investors to gain exposure to Japanese Yen without transacting in foreign currency markets. The ETF has $229 million in assets and charges a 0.40% expense ratio.
Returns
The FXY ETF has delivered poor historical returns, with negative returns of -9.4%/-7.3%/-4.9%/-3.9% on 1/3/5/10Yr time frames to March 31, 2023 (Figure 1). This has tracked the historical returns of the Japanese Yen spot rate, which returned -8.8%/-6.7%/-4.4%/-3.4%.
Figure 1 - FXY returns vs. USD/JPY exchange rate (invesco.com)
The main reason for FXY's poor performance is because of the Bank of Japan's dovish monetary policies. Since September 2016, the Bank of Japan had been engaging in yield curve control ("YCC").
Students of economics should have heard of the Mundell-Fleming trilemma . Essentially, the trilemma states that policymakers in any economy can only control 2 of 3 possible things at any given time: autonomous interest rate policy, fixed exchange rates, or free flow of capital (Figure 2).
Figure 2 - Mundell-Fleming Trilemma (Investopedia)
In the case of the Yen, as it allows capital to flow freely and the Bank of Japan ("BOJ") kept Japanese interest rates at zero , therefore, the exchange rate of Japanese yen was the variable that has to fluctuate to compensate.
For many years, the Yen actually kept pace with the USD, as both the Fed and the BOJ kept interest rates at rock bottom levels. Since YCC was implemented, the USDJPY exchange rate was stable within a broad 100 to 120 range (Figure 3).
Figure 3 - USDJPY broke out of downtrend due to inflation and Fed interest rate policies (Author created with price chart from stockcharts.com)
However, as inflation surged in the U.S. beginning in 2021 and the Fed began tightening monetary policy in response, the USDJPY exchange rate rose rapidly (rising USDJPY means weakening Yen), breaking out of a multi-year downtrend.
In fact, the Yen fell precipitously by over 30% from the end of 2021 to September 2022, as it was one of the most profitable and crowded macro trades in 2022 The Yen's weak performance alarmed Japanese central bankers and they intervened in the currency markets for the first time in years.
BOJ policy intervention and expectations that the Fed will slow down its pace of interest rate hikes caused a sharp reversal in the USDJPY exchange rate, with the Yen strengthening by over 10% since October.
Is Ueda Less Dovish Than Kuroda?
Also helping the Japanese Yen in the past few months was expectations that after the uber-dovish Governor Kuroda retired in April 2023, any incoming BOJ Governor would revisit the BOJ's monetary policies and normalize them relative to the rest of the world.
However, bullish Yen investors were negatively surprised on April 27th, 2023, when the newly appointed Governor Ueda announced plans to maintain Japan's ultra-low interest rates and stressed that the BOJ needed "to wait for more evidence to conclude inflation would sustainably achieve the BOJ's 2% target." With Japanese inflation currently running at a 3.2% YoY rate after touching a multi-decade high of 4.3% YoY in January, it is comical that that the BOJ still has not yet concluded that inflation has reached its 2% target (Figure 4).
Figure 4 - Japanese inflation at multi-decade highs (tradingeconomics.com)
More importantly, Governor Ueda also announced a monetary policy review that will last one and a half years. Although he stressed the BOJ may alter monetary policy before the end of the review, the length of time budgeted for the review suggests the BOJ is in no hurry to normalize interest rates with the rest of the world. This sent the Yen tumbling by more than 1.7% on April 28 (Figure 5).
Figure 5 - Yen plunged on April 28 following dovish BOJ comments (investing.com)
Cautious BOJ May Lead To Replay Of 2022
As a reminder, since October, the Fed and the ECB have raised their policy rates by 175bps and 225bps respectively. So, purely based on interest rate differentials, the Yen should be even weaker than in October.
Technically, the USDJPY FX rate is currently in a triangle formation, suggesting indecision (Figure 6).
Figure 6 - USDJPY in triangle pattern (Author created with price chart from stockcharts.com)
If the dovish comments from Governor Ueda causes the Yen to weaken further, to say 135 USDJPY, we could see a replay of 2022 as bearish Yen traders re-enter their shorts.
I believe the current juncture is a good place to short the FXY ETF with a stop at $70.00 (the breakdown level), playing for a re-test of 2022 lows at $62 (Figure 7).
Figure 7 - FXY is a good short here (Author created with price chart from stockcharts.com)
This target is achievable given interest rate differentials between the Yen and USD are actually wider now than in 2022. This trade risks $1.50 for $6.00 of potential gains, but do note the cost of borrowing presented below.
Implementation Through Puts
Although the FXY ETF is shortable, the cost to short it may be prohibitive at 11.55% annualized (Figure 8).
Figure 8 - FXY is a little costly to short (Interactive Brokers)
Instead, investors can consider put options on the FXY ETF, for example, a September 66/63 bear put spread can currently be bought for a $0.80 credit. From figure 7, given my expectation of a re-test of the 2022 lows, this put spread should cover most of the move. The maximum gain from this trade would be the difference between the two strikes or $3.00.
Alternatively, a December put spread with the same strikes will cost $1.25. Going farther out to December will give investors more time for the trade to work, however, it will cost more in premium, so the return / risk is lower.
Risks To Trade
Of course, the biggest risk to my call is if the BOJ intervenes in the currency markets again or if Governor Ueda turns hawkish, and normalize BOJ monetary policy with the rest of the world. If that occurs, I expect the Yen to strengthen materially.
A good sign that we are wrong would be if the Yen strengthens through 129 on the USDJPY exchange rate. I would use that as a stop loss.
Conclusion
With the incoming BOJ governor conservatively maintaining his predecessor's ultra-dovish policies with a monetary policy review process that is going to take one and a half years, we could see the Yen resume its weakness from 2022. I believe now is a good risk/reward level to short the FXY ETF, playing on the indecisiveness of the incoming BOJ governor.
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FXY: Dovish BOJ Could Signal FXY Weakness