Deutsche Bank - Yen reloaded

The JPY leverage trade, in play since 1995, may not have been completely unwound.
The probability of a bout of risk aversion is high over the coming months, and JPY would benefit most.
We like to buy the JPY vs the USD as the best insurance trade against risk aversion,, and it is out-ofline with yield differentials.

Deutsche Bank - USD/JPY Looking Ahead
Yesterday’s New York View outlined a framework that explained moves in USD/JPY over the past few years. Running out of sample over 2009 the framework also provided an explanation for developments in USD/JPY over 2009. While we offered up two scenarios for USD/JPY – one for bulls and one for bears - we left open where we thought USD/JPY might go from here. And the scenarios we offered were (by design) perfect storms. Today’s New York View offers some thoughts on where we see the risks around the drivers of USD/JPY identified yesterday (namely US 10-year yields, the US / Japan two-year interest rate differential and volatility), and hence also USD/JPY. Our timeframe is 1-2 months.

Taking the ‘easiest’ one first – with policy rates in the US and Japan on hold the two-year interest rate differential is unlikely to move all that much – with this providing some degree of an anchor. A strong run of (more) upside US data surprises would be the biggest risk here, although given the tendency of surprises to mean revert we’d expect the data flow to eventually become a little more two-way. So for now we’ll put the two-year interest rate differential to one side. On volatility there remains scope for a modest further reduction over coming months. We’d expect, however, that around 30 in the VIX and 12 on the CVIX should mark a low over a 1-2 month horizon – with a further decline in vol beyond that likely needing a solid ‘V’ emerging in the real economy. So a little more downside is possible, but if there is a large move in vol over our 1-2 month time horizon we’d expect it to be to the upside, not the downside.

Looking at both nominal and real 10-year yields against the ISM suggests both have already factored further gains in the data over coming months. That leaves us thinking that yields are unlikely to rise too much above levels seen last week. Indeed our bias would be for yields to move lower over the next 1-2 months. For the purposes of this exercise, however, we’ll consider US 10-year yields at 3.50% as being an ‘upper bound’ – i.e. about 10 basis points above where we got to last week. Plugging the average two-year interest rate differential observed over the past month, a US 10-year yield at 3.5% and the CVIX at 12 into the USD/JPY model we outlined yesterday gives a USD/JPY rate of 100.5. Given we think moves above 3.5% in US 10-year yields and a sustained drop in the CVIX below 12 is unlikely over the next few months we would be comfortable selling USD/JPY around 100 in order to take advantage of our bias toward lower US yields; and the risk of a renewed spike higher in volatility.