Excell with Options: Exploring Central Banks as a Catalyst for JPY/USD Options
Report highlights
- 12-month TIBOR compared to US 12-month Bill yield, both overlaid with USD/JPY spot
- 10-year US Treasury yields less 10-year Japanese Government Bond (JGB) yields compared to USD/Yen spot
- Commitment of Traders report for Yen
- Economic Calendar of catalysts per QuikStrike and CME Group Event Volatility Calculator
- Expected return for a JPUV4 72/74 1 by 2 Yen call spread
This week, Rich Excell discusses the yen's fascinating position with fundamentals, positioning and volatility dynamics. Additionally, Rich explores a spread strategy involving selling and buying strike calls in a way that's built to mitigate vega risk.
Image 1: JPY USD Three-Month FX basis compared to USD/JPY FX spot rate
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.
Image 2: 12-month TIBOR compared to U.S. 12-month Bill yield, both overlaid with USD/JPY spot
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?
Image 3: Bank of Japan Balance Sheet as a % of GDP, Federal Reserve Balance Sheet as a % of GDP and the spread between them compared to USD/JPY spot
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?
Image 4: 10-year U.S. Treasury yields less 10-year Japanese Government Bond (JGB) yields compared to 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.
Image 5: Citi Economic Surprise Index U.S. less Citi Economic Surprise Index Japan compared to USD/JPY spot
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?