The foreign exchange market remains one of the biggest in the world, with the BIS survey in 2022 showing a $7.5 trillion daily turnover. At Tricio we have deep roots in FX research and trading as all three of the principals, John Calverley, James Chu and myself, have worked in FX markets (wholesale and private banking trading, derivatives, sales, and research) in our careers. FX markets can be very simple to understand sometimes as higher interest rates can support a currency, for example, while at other times the subtleties of flow and sentiment can baffle the most experienced practitioners. The quote below from Fed Chair Greenspan in a 2004 speech is always good to reflect on.
‘My experience is that exchange markets have become so efficient that virtually all relevant information is embedded almost instantaneously in exchange rates to the point that anticipating movements in major currencies is rarely possible. The exceptions to this conclusion are those few cases of successful speculation in which governments have tried and failed to support a particular exchange rate.
Nonetheless, despite extensive efforts on the part of analysts, to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin. I am aware that of the thousands who try, some are quite successful. So are winners of coin-tossing contests. The seeming ability of a number of banking organizations to make consistent profits from foreign exchange trading likely derives not from their insight into future rate changes but from market making.’
Greenspan was not fond of central banks intervening in the FX markets, and many FX market participants share the view that central bank intervention does not work. We take a more nuanced view at Tricio – intervention works to create ‘two-way risk’ if only for a brief period of time. More importantly, intervention can work if market sentiment has taken FX rates to extreme levels.
The yen weakness may be worth thinking about as being an example of the latter. John and I have talked about why in Currency Matters (our monthly FX publication) and in many of our podcasts. While we were happy to be bullish on the USD and looking for the JPY to weaken from the 2020 USD lows to probe above Y140 and test Y150, recent USD gains seem a stretch to us. Market commentators are happy to talk about how the positive USD ‘carry’ has to see the USD continue to rally vs. the JPY, ignoring the fact that the USD had positive carry even at times when the JPY was trading very strongly. The long term chart below underlines our view on risk. The USD could trend higher to challenge the flat orange line (Y177 key chart point, or Y180 psychological area) and then set up gains to Y200 or higher. Or if the current bout of BoJ intervention works to change sentiment, a pullback to key USD support levels could be seen instead.
The Y152/Y150 zone in the chart below (flat purple line) and then the Y145 area (rising red line) are worth noting as potential USD support levels to watch. A push below these would open up bigger potential to Y127/Y125, in line with our long term forecasts.
One thing we like to keep an eye on is the pain threshold in FX markets. While FX market commentators always focus on the spot rate, the big moves often happen in the forward market. We look at forward risk as a research tool for emerging market FX rates as the interest rate differentials can be very high at times. Otherwise sensible investors can be drawn into buying high interest rate emerging market currencies and borrow in lower yielding currencies to make the ‘carry’. They often do this in the forward market, on the bet that over 3-months, 6-months or a year the positive carry will be bigger than any FX loss. This works until it doesn’t.
The ‘pain threshold’ is when the spot rate moves so much that the ‘carry’ is wiped out. My experience with speculators and hedgers is that this is when the phone rings (or email or direct message arrives) with the client/counterparty asking ‘what do you think I should do?’. Our proprietary indicator (RAM Forward Model) measures this pain threshold by looking at the current spot rate vs. a blend of forward rates projected in time. So we look at spot vs. the 3-month forward from 3-months ago as part of this indicator, for example. The chart below shows the daily plot of USD/JPY with the RAM model. The indicator is turning lower just now, underlining the pullback from Y161+ probes seen over the last sessions.
The monthly model below gives a smoother look at the moves. This may be a coincident indicator at best, but we don’t look at this tool just for timing. Rather, we like to look at the levels. The 3-month forward from 3-months ago is near Y157 now. The 6-month forward from 6-months ago is near Y152.50 and so on. As these levels give way, speculators and hedgers who put those positions on or are monitoring them will need to make decisions. Double down or cut/change positions?
Our view? Simple really. The Fed is set to lower rates, the BoJ has started raising rates. The BoJ has been leaning heavily against yen weakness since the Y152 zone gave way. They are likely to continue to do so if the yen weakens much further. On a pain threshold view, a push below Y152/Y150 may be very interesting to see if yen shorts step up again, or if they cut and run back to much lower USD levels.
Gerry Celaya, Chief Strategist
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