Strategic trade
Trade view / 20 September 2016 at 15:03 GMT

Yen to pound sterling

Managing Partner / Spotlight Group
United Kingdom

Two major central banks will deliver their next rate decision on Wednesday. The Fed will probably leave rates unchanged. However, before we focus on Washington DC our attention will be on Tokyo where the Bank of Japan will decide whether to cut rates even further, buy even more bonds, perhaps reduce its bond purchases or, maybe, sit on its hands in a “wait and see” approach by doing nothing.

One factor has been emerging of late in that the BoJ could try and engineer a partial step of normalisation by attempting to steepen the yield curve by buying more short-dated paper while buying fewer long dates. 

That means steepening the 2/10 curve. This process has been underway as the following 2/10 spread data reveals:

One Year Ago +31.5bps One Month Ago +12.8bps September 20 2016 +20.7bps

The motivation behind seeking to engineer a steeper yield curve is that if there is a perception that the economy is improving it is likely that investment for the long term will accelerate. That implies the price of long-term borrowing will rise and so a higher yield differential between say the two and 10-year JGB’s is fully justified.

That may well give a short-term boost to the yen. However, finding a currency pair where the yen has the upper hand is no simple matter. Japan faces many problems such as the developed world’s biggest government debt relative to GDP at 229%, by an ageing workforce and by an entrenched culture of deflation last recorded at -0.4%.

To foster more growth and hence inflation one would imagine the BoJ would seek a softer yen on a trade-weighted basis. I think there is going to be headwinds for the BoJ to weaken the yen, for whilst the sheer power of the BoJ in the JGB market can engineer a steepening it is an invitation for market speculators to buy yen so as to finance short-dated JGB purchases as they ride of the coattails of the BoJ reverse twist *.

*“Twist” is where the central bank uses the proceeds of its sales from short-term government debt, e.g. Treasury Bills or notes to 2-year to finance the purchase of longer-term government debt.

I expect that the yen will fail to make much progress against the dollar, however, against sterling where there are many uncertainties as to the deal the UK will get on leaving the EU, I see the yen making further gains.
 Source: Spotlight Ideas

The chart above captures the 16.7% collapse in the value of GBPJPY immediately following the decision to leave the EU. Since then one can see that the pair have rotated between 129.50 and 141.00 in a rather aimless manner.

The 10-year chart below shows that the yen could be perceived as being quite toppy relative to the Sterling, however, if the BoJ do opt to steepen the JGB yield curve I believe all the time technicals which are all for selling sterling will be justified and the yen can drive the pair down toward 120.

GBPJPY10-Year Chart:
 Source: Spotlight Ideas 

Management and risk:

Parameters: GBPJPY
Entry: Sell 131.81 1421 GMT
Targets: 129.41 ... 127.24 ... 125.29 tending to 120.00
Stop: 134.30
Time horizon: Strategic Trade

— Edited by Clare MacCarthy

Non-independent investment research disclaimer applies. Read more
20 September
AVLion AVLion
Thanks for your in-depth analysis n its really helpful. Assumption on JGB regarding steepening curve is knowledgeable.
Thanks again Steve
21 September
AVLion AVLion
Dear Steve,
As you stated in your analysis Japan has done almost what you have expected.
21 September
Stephen Pope Stephen Pope
Now to see if ¥ can make headway.
Nothing will be clear until the Fed result.


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