The Japanese Yen (JPY) is one the top eight traded currencies in the world, and easily, one of the top four.
What makes JPY so special?
What drives JPY price in FX markets?
Is there an end to this madness?
We’ll cover all these questions below.
If you’ve taken any introductory economics course you’ve likely heard this before:
Price of a good or service depends on supply and demand.
If demand is bigger than supply, you have a shortage: price goes up.
If demand is lower than supply, you have a surplus: price goes down.
This is overly simplistic model, but it’s amazingly useful when it comes to analyzing market forces.
The Japanese Yen (JPY) is a currency, but it is also a good.
You can buy or sell JPY with other currencies.
And JPY’s price is its exchange rate VS the other currency.
Thus, if USD/JPY is 110.05, then JPY’s sell at a rate of 110.05 Japanese Yen per United States Dollar (USD).
Conversely, you can buy 110.05 Japanese Yen with a single American Dollar (USD).
Note: this is also an oversimplification (to explain the concept). In practice, every broker will have a spread (difference) between buy and sell prices.
Now that we’ve established JPY as a good like any other (and like any other currency), which variables drive JPY price?
Anything which influences demand and/or supply.
For our purposes, we care about only the real market moving drivers.
In other words, those events that really matter.
We can divide them into two:
1. Safe Haven Flows; and
2. Monetary Policy changes by the Bank of Japan (BoJ).
Let’s jump right in.
If you don’t know what safe haven flows are, you can check that out here.
But in a nutshell, it’s when investors and traders move money out of risky assets (like stocks) into safer assets such as gold, or currencies like JPY or CHF.
There are two ways in which a flight to safety can occur:
_Unwinding of risky positions (financed by low-yielding JPY); or
_Loading up on JPY as a deposit of value (it wasn’t originally financing risky positions).
In both cases, safe haven flows occur due to some event shaking investors up and bringing uncertainty to the markets.
Something like the President of the United States fanning the flames of a potential nuclear conflict with an opposing nation.
Or, a huge financial meltdown due to overleverage in the housing market.
Or a sovereign debt crisis messing financial health of an entire continent…
You get the idea.
There’s one difference between the two cases though.
The first one happens much more often than the second.
Since JPY has had an incredibly low interest rate (negative) for so long, many funds invest in risky assets by shorting JPY.
For example, the stock market in the US is gaining, so foreign investors decide to buy stocks by first buying USD/JPY (they finance their intermediate USD purchase by shorting JPY).
When you hold a position longer than a session, you pay or receive the interest rate differential between the currencies.
So if you want to hold or invest in AUD, with a high (compared to other majors) interest rate of 4%, you should do it by shorting a low-yielding currency.
Thus, many funds choose to short JPY because it has a rock bottom yield (which increases the interest rate differential, making the fund gain in the process).
When things get too risky though, and risky asset valuations will suffer as a result, investors liquidate some of their positions in these assets.
If they financed those purchases by shorting JPY, then they reverse this flow.
As an illustration, if a fund purchase USD/JPY, now it shorts USD/JPY (essentially selling the Dollars to buy back the Japanese Yens, and close the initial position).
Still following me?
If that was interesting, you may have what it takes to make money trading forex. If not… well you can still make money (I’m not gonna’ lie!)
Do you remember our second case?
If people start buying JPY because they want to preserve value (as opposed to closing an initial position), then sh$t most likely hit the fan.
A strong move like this one happens with a very powerful event.
It scares people off.
Enough about safe haven flows and JPY. Now tell me about the other driver.
Monetary policy by the Bank of Japan (BoJ) is the single most powerful driver of Japanese Yen value.
Lately, since there hasn’t been much new, this driver has been relegated to the backseat.
However, as soon as the BoJ hints at mixing things up, JPY will react.
Like with any other currency, tightening or loosening (change in supply of the currency) by the Central Bank is the single most powerful driver of price.
Thus, pay attention to the Governor of the Bank of Japan!
Seriously, monetary policy decisions are by far the best ways to make money consistently trading FX markets.
So pay attention. When a decision (or a forecast revision) surprises the markets, the currency moves big time!
That’s it for now.
See you soon,
The Forex Economist
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