Game plan for trading usd/jpy this week

Bank of Japan meeting tomorrow

The year’s first Bank of Japan meeting is tomorrow. Last month’s unexpected widening of the 10 yr yield curve control band ushered in a new era of monetary policy normalization and an exit from ultra-low interest rate policy. What Chairman Kuroda decides at tomorrow’s meeting will have large consequences for the Japanese yen, Japanese government bonds, and global fixed income markets in general. If you didn’t see my previous post in late December about the BoJ, I highly suggest reading it. You can also check out my original trade idea of shorting usd/jpy when it was at 141. I’m still short going into tomorrow’s meeting.

The backdrop: On Dec 20, the BoJ announced that they will cap 10 yr JGB yields at 50 bp, up from 25 bp, by buying unlimited amounts of JGBs in the market. Kuroda said the move was not a tightening of policy, but rather was an attempt to restore “functioning markets”. JGB yields quickly jumped to that ceiling, and since that meeting the market has sold an ungodly amount of JGBs into the BoJ’s bid. The BoJ was forced to buy $78B worth of JGBs last week alone, an amount rivaling the Fed’s monthly purchases of Treasuries and on track to beat last month’s amount, which set a record.

If the goal was to restore functioning markets, the BoJ is still a long way off. The BoJ owns more than half of the entire JGB market, and that share is growing. The clearing price of 10y JGB yields is much much higher, as Japan core CPI is 2.8% and rising. The yield curve at the 10y point is also kinked due to the distorting effect of the BoJ’s unlimited buying at 50 bp.

If the BoJ does nothing tomorrow and puts off the decision to widen the band until its March meeting, they will have to defend the 50 bp cap for another 1.5 months against the hordes of JGB sellers, resulting in them swallowing an even greater share of the JGB market. While some analysts believe the BoJ will make small steps (or none at all) in order to not rock the boat before Kuroda leaves, my sense is that Kuroda does not want his last few months in office and legacy to be marred by a dysfunctional market that his successor gets tasked with cleaning up. This is why I believe they will do something tomorrow to widen the band.

Scenario analysis:

1. Do nothing, 20% probability. This would be a disappointment for usd/jpy and JGB shorts expecting a hawkish change in policy. Short covering would send usd/jpy 4-5 BF (big figures) higher over the next 24 hrs, but I think it then rolls back over and revisits the Jan low within a few weeks.

2. Expand the 10y ceiling to 75 bp from 50 bp, 10% probability. This would barely exceed the market’s expectations and result in a knee jerk 1-2 BF spike lower but then a subsequent squeeze over the following hours or days. This move would not achieve the BoJ’s goal of being forced to buy fewer JGBs. The market will immediately start pushing for 100 bp in the next meeting, and the BoJ will likely still need to intervene heavily in the market to hold the cap. Why is this? If you extrapolate where the 10y yield should be based on the 7y and 15y points of the curve, it should already be at 75 bp.

   

   However 75 bp is not the clearing price as this doesn’t account for the entire curve parallel shifting upwards, just as it did when the yield cap was lifted from 10 bp to 25 bp. The middle of the curve (7-15 yr) shifted 35 bp higher as a result of the change in the band. The eventual shift in the curve would result in the 10y point still being too expensive to alleviate further selling.

   

3. Expand the ceiling to 100 bp, 40% probability. This would exceed the expectations of the market and result in usd/jpy immediately falling 4 BFs and remaining in a lower trading range. The move would temporarily take pressure off the BoJ from buying more JGBs from the market, while being incremental enough to not politically rock the boat. However, at some point between now and the next meeting, JGB selling pressure will return. The Japanese government will publicly name the nominees for the next BoJ Governor, and the makeup of this slate will trigger speculation that the BoJ will become even more hawkish after Kuroda leaves in April.

4. Abandon YCC at the 10 yr point of the curve and move it to the 5 yr, 30% probability. News services MNI released an article last week speculating about this option. Usdjpy would fall 4 BFs and trend lower. If they go down this route, my guess is they would cap the 5y yield (currently 35 bp) at 50 bp or higher. 10y yields would immediately spike to at 100 bp or more. With 10y JGBs completely untethered, there could be some significant upside volatility in yields, and by extension, downside volatility in usd/jpy. I would expect the BoJ to intervene to smooth the selloff.

The scenario analysis favors the BoJ exceeding the market’s expectations, and therefore it makes sense to go into the meeting short usd/jpy or long puts. Outcome #1 (20% probability) results in an immediate loss, so the position would need to be sized to survive that if it happens. I’m personally sticking with my usdjpy puts, but I would take some heat on them if outcome #1 happens. However I wouldn’t be forced to stop out, and I would survive to see the market roll back over in anticipation of the next hawkish BoJ catalyst.

As usual, my view is just one of many, so one should not take this as financial advice, and should consider other viewpoints before putting money on the outcome of this meeting!

Current portfolio:

Links to original open trade ideas:

Short usd/jpy, long XAU, 5-30 Treasury Steepener, Long Dec 23 BAX futures

Long eur/chf

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