It is impossible to trade USD/JPY these days without keeping a close eye on developments on the Korean peninsula. The nuclear ambitions of North Korean dictator Kim Jong-un have many traders asking what’s in store next for this currency pair. While economic fundamentals, political tensions and intermediate-term technical all bode well for yen strength, there are many other reasons for yen bulls to proceed with caution.
Fundamental Strength
The fundamental case for the yen couldn’t be stronger. As a net exporter, Japan boasts healthy trade surpluses with the United States that keep a strong bid in the yen. In July 2017 exports rose 13.4% from the previous year. It was the eighth consecutive month of export gains and produced a surplus of JPY 418.8 billion, which exceeded consensus estimates.
Political Tensions
The political tensions with North Korea also favor yen strength. Negative interest rates in Japan have produced a massive yen carry trade in which traders borrow yen to invest in higher-yielding currencies. If a flare-up in tensions leads traders to unwind these trades and return to more stable assets, then the yen may spike higher in reaction. Even a flight to US treasuries could ultimately lead to yen strength. If Treasury yields decline dramatically in response to this flight to quality, investors might see value in the yen.
Technical Indicators Say Strength
USD/JPY has solid intermediate term resistance at 109.4. After touching this level on September 6, the chart put in a long candle and then broke down below the 4-hour EMA of 108.94. There is room for more downside since the pair breached long-term support at 108.09 on September 7.
The Unknowns
While the political, fundamental and technical factors suggest continued dollar weakness and yen strength, there are ample reasons for caution.
With respect to North Korea, there are many scenarios that could upend the yen strength case. Increased US defense spending could bolster US GDP growth, and the dollar should benefit at the expense of the yen.
In the cataclysmic scenario that Japan is damaged in a North Korean nuclear attack, it is possible that the yen reacts negatively. Foreign investors represent 30% of investors in the Japanese stock market and may withdraw capital. On the other hand, Japanese companies may repatriate capital from abroad to rebuild infrastructure. Japanese investors hold $3.1 trillion in foreign holdings and bringing these funds home could be a powerful catalyst for yen appreciation.
Volatility May Be the New Norm
All of the geopolitical uncertainty suggests that USD/JPY may experience extreme periods of volatility through the rest of 2017. For traders looking to enter positions, there may be opportunities for large profits. However, we should consider risk mitigation as an important part of any trading strategy.
Traders should consider utilizing stop-loss orders on positions to avoid large P&L swings. We can take advantage of profitable trades by employing tighter trailing stops. This ensures that we limit our downside while preserving profits.
Options as a Tool
The Philadelphia Stock Exchange offers World Currency Options Trading products for all of the major currency pairs including USD/JPY. Traders who are more experienced can utilize options as an effective hedging tool. An interesting strategy may be to play the trend of yen strength by shorting USD/JPY, but hedging with the purchase of out-of-the-money dollar calls / yen puts. Of course options cost money and out-of-the-money calls are expected to expire worthless. This strategy will only work if the movement in the underlying currency pair offsets the cost of the options.
I hope these thoughts about the catalysts driving USD/JPY spur some trading ideas. Ultimately, however, risk management should be at the forefront of every trader’s mind. Caution will be the name of the game for USD/JPY for at least the rest of 2017.
