It is hard to not have heard about the yen carry trade if you have been following the markets over the past month, particularly on August 5. Traders can debate the cause and effect of what transpired around that time, but suffice to say, levered accounts had risk to unwind with the catalyst being the move in the yen. As one can see from the chart above, as the yen basis collapsed, there was a sharp drop in the USD/JPY spot. In fact, over the last year, the direction of basis and the direction of spot are quite correlated, albeit with some noise. Since August 14, however, markets have seen a dislocation, as the yen basis is suggesting higher USD/JPY while the spot prices continue to probe lower levels.

Depending on who you ask, the catalyst for the collapse in basis and the drop in spot was either the surprise move toward higher rates from the BoJ or the negative economic data in the U.S. that crystallized the FOMC need to lower rates. Leaving that aside, it is clear that over the last few years, when markets have seen yen rates move up vis a vis U.S. rates, there has been a drop in USD/JPY spot. Look at the end of 2022 period that I have highlighted with the two vertical lines. At this time, yen rates, as measured by the 12-month TIBOR, started to nudge higher, while the same U.S. 12-month yield stayed constant. This was perhaps the result of a possibility of BoJ intervention that occurred, driving spot lower from 150 back to 130. Once U.S. rates started marching higher again vs. Japan, USD/JPY spot price resumed marching higher. In the recent episode, highlighted by the vertical lines, one can see an even sharper move higher in 12-month yen yields, which corresponded with a fall in U.S. 12-month yields, not a leveling. Traders have seen a move lower in USD/JPY spot from 160 to 145, but given the magnitude of the relative move in rates, particularly when compared to late 2022, has the strengthening of the yen been enough? It is clear post-Jackson Hole that the FOMC is embarking on an easing cycle and the market sees up to nine cuts by the end of 2025. The BoJ has also indicated higher rates are a strong possibility. Should this suggest that the USD/JPY spot should continue to move lower?

As one might suspect, rate moves are not the only tool in the central bank toolkit. Another powerful tool that has been used extensively in the post-Great Financial Crisis period is growing or shrinking the central bank balance sheet. While the Federal Reserve is focused on quite a bit for their moves, the Bank of Japan has been much more aggressive on this front. The top chart shows each central bank’s balance sheet as a percentage of GDP. You can see that while the Fed’s balance sheet maxed out at 35% of GDP in 2022, The BoJ’s balance sheet hit a peak of more than 130% of GDP. In addition, while the size of the Fed balance sheet has begun to shrink over the past two years, down to 25% of GDP, the BoJ balance sheet is still quite elevated at 125%. If the BoJ wants to begin tightening policy, will traders see a change here? 

The bottom chart looks at the difference between the two central bank balance sheets in a custom index I created. I compared this to the USD/JPY spot rate. As the BoJ was easier in terms of balance sheet growth, the USD/JPY spot moved higher. It was not a perfect correlation as one can see there were some extended periods of dislocation. However, there is a relationship that makes sense. If the BoJ begins to tighten policy vis a vis quantitative tightening much more than the Fed, could this put more downward pressure on USD/JPY spot?

A measure that may encapsulate both the rate policy as well as the balance sheet shrinking may be the 10-year government bond yield in each country. I have shown this before where the spread or difference between the 10-year U.S. Treasury yield and the 10-year JGB yield plots vs. USD/JPY spot. One can see here that this spread has been falling, and actually leading the move in spot that we saw in early August. The bond market had been indicating that USD/JPY spot was too high based on these fundamentals. The BONDJG Index still looks to be pointed lower.

Driving these different central bank policy decisions may be the relative performance of each economy, at least compared to what is expected by economists. Citi has economic surprise indices for each country. These are mean-reverting indices that show how economic data is being reported relative to what is expected. The white line on this chart is the difference between the economic surprise index in the U.S. vs. Japan. As this line heads lower, it indicates that U.S. economic data has disappointed expectations more than Japanese data. This may be the reason that the Fed has gotten easier in absolute and relative terms while the BoJ has gotten tighter. To the extent this continues in the short-term, could this be another catalyst for lower USD/JPY spot?

I have been making the case for a stronger yen, but what are the technical charts saying? For this, I look at the daily and weekly Ichimoku charts that also contain the MACD and RSI indicators. In the top chart, the daily measure is indicating that the yen is potentially overbought here, or at least working off an overbought condition, with the MACD also trying to turn lower. While not a strong signal, this is not necessarily a chart that gets me bullish yen. Let’s take a look at the weekly chart because there could potentially be a meaningful trend change in the narrative above. One can start to see this in the weekly chart. The Ichimoku cloud has flattened out, even before the move higher in yen indicating that the trend toward weaker yen, which markets have seen over the last several years, has been losing some steam. The MACD has turned higher suggesting a counter-trend move, and the RSI is not overbought yet on the weekly, indicating there may be more room to run. If I go back to the cloud, I can see that there is good resistance up to .0072, however, a break of that level could point to considerable upside in yen, especially if it coincides with a move higher in the lagging span, which is also approaching the cloud. While not a clearly bullish chart, it does say that if resistance is breached above .0072, there could be scope for a much bigger move.

In order to get a proxy of positioning, I look to the Commitment of Traders report. While the COT report looks at positioning in the futures market rather than the spot market, it does a good job of capturing the sentiment that exists market wide. As one can see, coincident with the sharp move higher in futures (lower in spot) in early August, the yen short position was materially closed. While it is not quite flat, it is very close to it. In addition, it is at the longest (least short) it has been in the last three years, mirrored only by the late 2022 period, when yen also had a sharp move higher and when yen rates also moved higher relative to the U.S. Will traders look to put the short back on as they did in early 2023, which led to a weakening of the yen again? Or will they actually take this to a long position at some point?

The next stop is to look at what the options market is pricing in. The first stop I take is to look at one-month USD/JPY implied volatility compared to some other measures of market risk. I do this because early August was largely a market event, and not just a yen event. I compare yen implieds to the VIX Index, a measure of 30-day SPX implied volatility, as well as credit spreads, as measured by the Moody’s Baa Corporate bond yield less the Treasury yield. One can see that these measures tend to move together over time, though the correlation is not perfect by any stretch. However, over the medium term, relationships begin to re-assert themselves. Right now, we see that yen implied volatility stays elevated, near the highs of the last few years while the equity volatility, as well as credit spreads, has normalized. Does this suggest that yen volatility might be a little too high right now?

In order to look at yen volatility relative to its own history, I bring up the CVOL tool from CME Group. In the bottom chart we can see that the direction of yen volatility, as measured by CVOL, as well as skew, a measure of upside variance vs. downside variance, are highly contingent on the direction of futures. If the yen strengthens, traders may see higher skew and higher volatility. If the yen weakens, they may see lower volatility and skew. 

If yen volatility is high, which it is relative to the last three years, and skew is still elevated, is the market suggesting there may be more strength for yen going forward? Either way, this does suggest that I want to be careful simply buying options because I am buying volatility at a level that is elevated relative to its own history as well as other asset classes. 

When the market is at a potential inflection point, I always want to look for the catalysts. These catalysts serve to get one side of the trade, either yen bulls or yen bears, to change their mind. In order to find out what catalysts are ahead, I go to the QuikStrike economic calendar and look at the high Impact events. Given the heavy focus on relative central bank policy, it is not surprising to see both the September FOMC meeting on September 18 as well as the September BoJ meeting on September 19 listed as high impact. The combination of these two events, along with the commentary from central bank presidents, could have a large potential impact. Is the market prepared for this catalyst?

In order to determine that, I bring up the CME Group’s Event Volatility Calculator. I put in the September 19 date that would encapsulate both meetings. The model then calculates what the implied volatility is embedded in the market just for those events, relative to all other options around it. One can see there is a very high event volatility of 22.93%, which is almost double all of the other implied volatility around it. Thus, I need to be very careful about buying any options that embed this event volatility. In fact, I interpret this as a reason to be careful and not lean net long options, because not only is yen volatility already elevated, but the event volatility is even higher than that. While going short volatility may seem scary, particularly since I am leaning bullish yen and volatility tends to track futures, I have to be very careful not to be too long vega either. 

Putting all of this information together, I want to find an idea that is long yen deltas (i.e., bullish the yen). The relative central bank policy, from rate moves to potential changes in balance sheet size, all indicate to me that this is a very likely direction for futures. While the short-term charts may suggest prices are overbought, there is the potential that on a move higher, perhaps driven by a catalyst of central bank meetings, it may be large. I don’t want to simply buy options though, because I am buying an implied volatility that is high relative to its own history, relative to other asset classes and based on the event volatility calculator. This tells me I need to find a spread that is pretty neutral vega but still has the potential for me to gain considerably in the event of a big move higher. 

When considering levels, I want to sell options around the 0.0072 level, which is resistance in the Ichimoku cloud. If the move higher is going to stop anywhere, it would be here. If the move stops, I want to be short options at that strike, either because implied volatility will fall, or because we will pin at that level, and I can maximize time decay. However, a break of that level tells me it could be a big move. Thus, I want to buy more upside options than I am selling. Yes I am buying a higher volatility, but if the move to that level happens, we see from CVOL and skew that implied volatility will be moving higher so I am less worried about being long out of the money yen calls. 

I want to pick an expiration that is beyond the catalysts and which doesn’t embed quite so much event volatility. Therefore, I look at the JPUV4 contract. The spread I decided to trade is a 72/74 1 by 2 call spread. The chart above shows the Greeks for this trade. First, the trade is close to premium neutral, in fact earning a tiny bit of premium. The graph on the left shows the payoff diagram. At expiration, if I’m at 74, this trade would be a big loser because things have moved above the short strike and not through the long strike. However, I think that possibility is low because I would have broken above the cloud. The break even to the upside is 76, after which the spread makes money on a linear basis. If futures move a lot higher, the trade wins. If futures move a lot lower, the trade makes a tiny bit of premium. It is only on a drift higher to 74 that the trade loses. 

Though, one important thing I want to point out: one can see in the graph a much smoother curve higher in profits. This is what the profits look like prior to expiration. Thus, if the move happens after the catalysts, before expiration, it will be marked to market very favorably. A trader may want to trade out of the spread on a favorable move higher, if they feel there is a risk of futures stalling. 

There is a lot here this week, but I think right now the yen is in a fascinating place. Perhaps a multi-year trend is changing based on a meaningful change in central bank fundamentals catalyst by changing economic outlooks. Positioning is as clean as it has been in years. The volatility market is suggesting a lot of potential energy in the near term. Using CME Group’s tools, traders can not only see all of this developing, but find potential ways to best take advantage of it. 

Good luck trading!

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