Fear driven markets and growing distrust of central banks favours JPY
When problems start to emerge in highly indebted slow-growth economies, it's not long before questions are asked about the viability of banks and once again this is happening in Europe. Expect intense forex volatility for the foreseeable future as fear dominates the markets.
It's difficult to tell if the current volatility is just a ‘hissy fit’ over slowing global economic growth, in which case it’s not necessarily that serious. Under these circumstances, markets will soon calm down and risk currencies will stabilise and carry trades will be re-established pushing down favoured funding currencies JPY and EUR. Or is this a precursor to another financial crisis? The only answer to that question at the moment is that whatever is happening still has further to run before markets once again find an equilibrium.
Traders should adjust their trading strategies for fast-paced volatile markets. That is aim for shorter time frames, smaller positions with wider stop losses. JPY and CHF are likely to remain in high demand with rallies punctuated by sharp reverses on releases of temporary good news – all characteristics of fear driven markets where traders can suddenly be whipsawed out of positions.
In many respects the global financial system and economy don't appear to be as precariously balanced as they were on the eve of the 2007/8 financial crisis. Many banks have deleveraged considerably, built reserves against bad loans, curbed some of their riskier behaviours and central banks are much more alert to signs of stress, despite a number of troubled European banks.
However, two very worrying factors remain:
1/ Debt continues to rise according to the central bankers’ bank – the Bank for Internationally Settlements (BIS). It notes that public and private debt is up 36% since the last financial crisis at 265% of GDP in developed countries. The only good news is that much lower interest rates make this debt cheaper to service for creditworthy borrowers. But debt can’t carry on rising indefinitely.
2/ The second problem, in some respects even more scary, is that the markets are losing faith in central banks and governments. They’ve failed to reignite self-sustained GDP growth, banish deflation or contain debt. The responses to negative interest rate moves by Japan and Sweden are telling – they’re creating the opposite effect of intended and are undermining commercial banks by squashing their margins and could, if they become too negative, drive out depositors’ money.
It’s possible that the European Central Bank may avoid pushing rates deeper into negative territory and may instead focus on increasing or trying new variations of quantitative easing to support the economy and the region’s banks.
Meanwhile, the Federal Reserve’s plans to raise US interest rates look increasingly forlorn.
Indeed, how much more market turmoil and evidence of slowing economic growth will it take to admit that? And given the prevailing scepticism over public institutions, will markets necessarily react with relief to such a move or with more volatility as underlying fears appear to be confirmed?
TECHNICAL ANALYSIS: USD/JPY – Temporary reversal in the trend
The flip side of making JPY, a trader’s favourite currency to fund carry trades is that when market sentiment turns sour, as it has been for much of 2016, it tends to rise as short positions are covered - not what the Bank of Japan wanted.
On top of qualitative quantitative easing, the BoJ has added negative interest rates – making it more expensive to hold JPY. In a sense it shot itself in the foot, because the move merely fed the existing negative sentiment, which is playing out on the currency charts.
However, strong negative sentiment in global markets has pushed USD/JPY down with a respite in recent days thanks to some positive news, such as Deutsche Bank offering to buy back some of its risker debt to calm investors. However, the effect of such news is likely to be short lived.
In terms of support levels for USD/JPY, those can be seen around 113.44, 112.42 and the most recent low of 110.97. Any resumption of market turmoil is likely to see all three support levels tested, though expect the BoJ to fight back against such a trend. In terms of resistance, 115.12, 115.84 and 116.80 are all potential levels. In a risk-off environment, USD/JPY should be able to quickly retrace losses, given the BoJ’s ultra-aggressively lose monetary policy.
A game changer for that rule book would be for the Fed to publicly declare that further US rate rises are off the table, as markets now suspect, or even reverse its existing rate rise. This would remove much of the impetus for holding USD.
By Justin Pugsley, Markets Analyst, MahiFX