The Short Yen Trade - Analyst Blog
Every Friday afternoon, the Commodity Futures Trading Commission (CFTC) releases positioning data for futures contracts called the Commitment of Traders Report. The data breaks out the number of long, short, and spread positions in a futures contract by investor (trader) type. The most general category of break out highlights holdings by reportable and non-reportable position holders. Reportable positions encompass holdings above specific reporting levels as specified by the CFTC and are broken down by large speculators and commercial traders.
The recent data on the Chicago Mercantile Exchange's (CME) Yen Futures contract caught attention and is getting focus among traders. The Yen Futures contract is a derivative play on the USD/JPY exchange change rate.
A few definitions:
Reportable traders represent the "big" money in futures market and include large hedge funds, big speculative investors such as commodity trading advisors, and the major commercial buyers and sellers. Non-reportable positions are traders involved in the market which hold contracts below the reporting threshold. The commercial or speculative status of these traders is unknown and most of these traders are traditionally viewed as smaller sized players.
The Commitment of Traders Report can be used to determine the positioning of the trade and provide insight into whether the market may be oversold or overbought. One way to focus on positioning is to look at the non-commercial reportable position as a percentage of the total number of contracts outstanding. This ratio will highlight the degree in which large speculators are long or short.
A large speculative short base:
The graphic following displays the ratio of net non-commercial reportable positions to total contracts outstanding against the USD/JPY spot rate. The spot rate is based on Tuesday closes and corresponds to the same day that the CFTC measures market positioning for the Commitment of Traders Report. The negative value indicates that there are more shorts than longs.
The graphic highlights that large speculators are extremely short the yen futures contract on the CME. At last measures, 44% of the open interest was net short the yen futures contract. Being short the yen is easy to defend from a fundamental perspective. The Japanese government has enacted policies to weaken the yen and push inflation toward a 2% target level. At the same time, the interest rate differential between the U.S. 10 year treasury yield and 10 year JGB yield has widened in favor of the dollar. Since May, the 10 JGB yield has declined from over 90 bps to around 70 bps, while the US 10 year treasury has risen from just above 200 bps to as much as 300 bps. In recent days, however, the 10 year treasury yield has shown signs of decline.
The negatives for the USD/JPY rest in the Fed delaying tapering and the fact that the Japanese economy has displayed relative strength in recent months. Furthermore, there is great uncertainty over the political landscape in Washington D.C. with a potential battle over funding the U.S. government and the raising of the debt ceiling.
Playing the contrarian:
Playing the contrarian, the heavy short base in yen futures could suggest the USD/JPY is on course for a meaningful set back or correction - the yen could be ripe to material rally. The graphic displays a number of periods where the net large fund position was 40% or more of total positions. Notice in most of these periods there was a decline in the net short and the dollar fell against the yen in the following period. If history repeats, the yen should strengthen as large specs unwind their positions.
Note that in playing for a stronger yen, you are working against the desire of Japanese officials and Abenomics. The Japanese are also poised to raise the sales tax in 2014 and this may work to slow the Japanese economy despite Japanese officials suggesting otherwise.
Positioning in the yen suggests the path of least resistance may be a flat to higher yen or lower USD/JPY exchange rate, while the short base is removed or worked off. Two non-leveraged products for playing yen strength include the CurrencyShare Japanese Yen Trust ( FXY ) or iPath Exchange Traded Notes JPY/USD Exchange Rate ETN ( JYN ).
The correlation between the USD/JPY and the Japanese stock market is strong. Specifically, the correlation between the USD/JPY and iShares MSCI Japanese Index ( EWJ ) is 0.95 over the last year. Thus, a strengthening of the yen could be a negative for Japanese equities. It may be time for investors to rethink or test their Japanese holdings.
Over the last year, the correlation between the USD/JPY and the 10 year U.S. treasury yield has been +0.62. The correlation is not overly strong, but certainly meaningful. The correlation suggests that drop in the USD/JPY could occur with a decline in the 10 year treasury yield. It may be a chicken and an egg game, but lower treasury yields would make the dollar less attractive relative to the yen assuming no material change in the JGB yield. Players may be short the yen and short the treasury market.
The correlation between the S&P 500 and the USD/JPY is 0.89 over the last year. Historically, the relationship between the stock market and the USD/JPY has been transitory, and shown plenty of instability, but the recent relationship suggests the equity market could see a correction on yen strength.
The CME's Yen Futures contract is a small slice of the foreign exchange market, but is it is a good sampling of positioning in the USD/JPY exchange rate. It suggests that speculators are an extremely large yen short, and as time progresses lack of a decline in the yen could force some short covering and repositioning. Those short the yen could be under pressure to book profits. Contrarian players may want to look for a rally in the yen against the U.S. dollar. The FXY ETF or JYN ETN can be used to capture a potential rally in the yen.
Below the surface, there has been a strong positive correlation between the USD/JPY and the U.S. 10 year treasury yield, the U.S. stock market, and Japanese stock market. If there is a meaningful appreciation in the yen, it could coincide with lower treasury yields, weaker U.S. shares prices, and a decline in Japanese stocks based on the correlation over the past year. Of these three correlated markets, the Japanese stock market has the largest correlation to the yen and would likely be most impacted by currency movement.
ISHARS-JAPAN (EWJ): ETF Research Reports
CRYSHS-JAP YEN (FXY): ETF Research Reports
ISHARS-7-10YTB (IEF): ETF Research Reports
IPATH-JPY/US EX (JYN): ETF Research Reports
SPDR-SP 500 TR (SPY): ETF Research Reports
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