USDJPY Fibs

The July 13 - August 7 rally in the USD/JPY pair that broke through a previous downtrending channel to the upside corrected at the 62% fibonacci as measured from the May 6 high. Interestingly this latest downturn has taken a bullish turn after retracing 62% from it's short term peak on August 7.

There have been bullish USD/JPY commentary from Forex.com as reported by bloomberg recently as well.

USD/JPY Fundamentals

I have compared Japanese trade balance data with the USD/JPY exchange rate to determine that the dollar could appreciate as much as eight cents in the next eight months.

USD/JPY exchange rate

Japanese exports and imports are both down, like the rest of the world.

Japanese trade balance (imports minus exports) turned signifcantly negative during December and January. This caused Japan to become a net importer during the worst of the global recession.

Trade numbers take a little while to work themselves into the exchange rate. I lagged the USD/JPY by 10 months and compared it to a 3 month average of Japanese trade balances. The results are depicted. The correlation is better than 83%.

Throughout 2008 and 2009, the correlation between USD/JPY exchange rates and Japanese trade balances has been positive.

Three month average trade balance is significant against the exchange rate at the 1% level. The regresion reveals the following equation.

USD/JPY = 109.126 + 0.00001498 * Trade Balance 3 Month Moving Average

Using this equation, excel calculated predicted what the USD/JPY exchange rate would be 10 months after the recorded trade balance.

The model explains 69% of the exchange rate movement so there are some errors to deal with. The residuals use USD/JPY exchange rates 10 months after the observed trade balance figure. They are calculated as Actual exchange rate - Predicted exchange rate. The results show that, as of July, the USD/JPY is the most undervalued iti has been since the begining of 2008.

Inflation Expectations Ahead of FOMC Meeting

Inflation expectations are above 1.92 again. Look for the Fed to bring an end to all their bond purchases.

New Correlation Charts

Here is how to read these charts which measure correlations and potentially profitable hedged carry trades. Daily periodic returns are the percent change (natural log) of the currency as per daily New York close.

The first chart measures the correlation between the DPR of 23 tradable currencies on FXCM. The bottom chart measures the correlation in the prices of the currencies. If the price is rising, a strong positive correlation will mean the other currency's price will rise as well. The middle chart displays how much interest will be earned if a trader takes positions in each of the corresponding currencies. If the correlations and interest rate swaps are positive, you can buy on pair and sell the other. Price appreciation (depreciation) will average zero and you are free to earn interest at FX leverage rates.

Currently, I am long AUD/USD and short EUR/USD. The AUD/JPY and CHF/JPY pair looks attractive right now and I may be adding that soon.

Positve Supply Shocks

A quick reminder about the macro environment: Positive supply shocks are characterized by lower prices and higher quantities demanded. They can be caused by lower input costs.

Year over Year Eurozone PPI numbers are down over 6%.

An old San Fransisco Fed article instructs us to focus on nominal GDP (or spending) to get a handle on inflation during positive supply shocks.

Hedging a Breakout

Selling the EUR/JPY breakout would have been an effective and profitable hedge against the NZD/USD and GBP/USD breakouts early in the Tokyo session today. All three breakouts to the upside failed and ended up costing me. It was apparent that the Euro was the weakest of the major currencies. Next time I will look to hedge my breakout plays with a long-reversal on the weak currency.

Long the breakout

Short the breakout