Why the USD/JPY Correction Was Inevitable

A week ago, I warned my readers that the vicious sell-off in stocks and currencies was overdone and due for a sharp correction.  The markets have complied nicely and given us large bounces in most asset classes.  Dollar/yen bounced from a low of 141.67 all the way up to 148.22  That is an enormous correction but given the size of the sell-off from close to 162.00 yen per dollar, warning my readers to prepare for this move higher didn’t require particularly astute forecasting.  Rather, it was based on a combination of technical analysis and common sense.  The technical analysis was easy since the short-term and medium-term indicators were all screaming, “CAREFUL, WILDLY OVERSOLD!”  The common sense aspect warrants a bit of further discussion.

Over the past twenty years, the average range in dollar yen, from high to low, has been 15.26 yen.  The annual range has only exceeded 20 yen five times during this entire period, including 2022, which was by far the outlier with a range of 36.47 yen.  The next largest range was 23.75 yen, which occurred in 2023.  In fact, we have had more years with a range of less than 10 yen than more than 20 yen. This year the range was already 21 yen, so on a pure probability basis, I knew that it would take something extraordinary to keep the dollar cascading lower without the technicals first moving back to a less oversold condition.  We were already testing the common sense limits of a high probability total annual range – and this entire down move had only taken twenty-five days. 

I was also sure that there were some other factors that would lend some reasonable short-term support to dollar yen as we approached the 140-142 levels.  In December of 2023, the market tried repeatedly, from the 7^th of the month onwards, to crack the 140.00 level and trade lower, but the support was rock solid.  The dollar never got below 140.25, and in January of this year, the dollar never traded lower than 140.80.  Markets have a type of peculiar memory which often has a type of magnetic force over the markets.  Sometimes this memory relates to market moves that occurred decades earlier.  Other times, it relates to more recent trading patterns.  In general, the highs and lows for a year are very important levels, and they will automatically attract a lot of interest as we approach them; particularly if we are approaching them after many months.  The lows for a year always attract a lot of initial buying interest, while the highs for a year always attract a lot of initial selling interest.

I like to simplify this categorization by referring to these sorts of levels as “energy” levels, or “energy” bands, areas that have turned out to be very important levels of support and resistance for major price swings.  Obvious bands are all-time highs and lows, but approaching all-time highs and lows is not a common occurrence.  Therefore, I like to focus on less obvious energy bands that will still give us a lot of information about the underlying strength or weakness of a market.  

Dollar yen certainly respected the multi-month lows that were established last December. But last week we had the good fortune to have one of the major currency crosses, the Aussie Swiss Franc cross, making a run at the all-time low.  I mentioned this in my write-up, but I didn’t focus on it as there was so much activity going on.  Rather, I just pointed out that it was testing the all-time low in the currency pair.  Below is a long-term chart of Aussie Swiss.

This cross is quite a fascinating currency pair as it has had such an astoundingly huge range.  It traded as high as 2.4946 in 1981, and at the peak of fear in March of 2020 it traded down to .6344.   Aussie Swiss is clearly a currency pair that can be highly sensitive to  major risk-off developments, with the Swiss franc typically benefiting during times of stress and great uncertainty.  During the panic last week, the cross made a short-lived run at the all-time low, stopping just nineteen pips short at .5363.  Again, it was an easy call to suggest that we were ready for a sharp technical bounce.  The market was extremely oversold on nearly every time frame, and making new all-time highs or lows typically recovers an enormous force that has been building up.  The recent force was already largely spent,  having already dropped by 11.7% during the prior three weeks.  This was a forced unwind of weak positions, rather than a fresh impetus.  In any event, the cross rebounded by more than 7% in the past week, which brings me to the key question of what do I expect next?  

After violent sell-offs and sharp technical bounces such as the one we just had in stocks and currencies last week, the normal trading pattern is for the market to settle into a trading range while the market volatility settles down.  We are now in the consolidation phase in stocks and currencies as the markets decide whether the recent sell-offs were the start of something much bigger, or just a technical correction as part of a larger uptrend. Volatility levels have been crushed from the highs last week, but they are still above the unsustainably low levels that I wrote about previously. My bias in dollar yen is for an ultimate move lower.  Only about half of the massive, short yen carry plays have been unwound, so there is still potentially a tremendous amount of pent-up yen buying that needs to be done simply to flatten positions.  Moreover, with inflationary pressures slowly coming lower, the Fed is almost certainly going to start its easing cycle soon.  This will put further downward pressure on the dollar in general, but on dollar yen and dollar Swiss franc in particular.

We are already seeing other central banks lowering their benchmark rates, and once the Fed joins in the party, one of the major supports for the dollar will dissipate.  This could easily lead to general dollar softness against most majors, but the way this develops will depend on many other factors such as economic growth, general market stability in stocks and bonds, and so on.  It is just too early to forecast a major broad-based dollar weakening scenario until we see how risk assets and general market conditions are developing.  Could I easily envision a further five or six percent drop against most major currencies?  Yes, but it is just a bit too early for me to commit myself.  

The election in the US will likely become quite rancorous over the coming weeks.  Let’s see how the markets respond to the prospects of the US election.  So far, the reactions have been muted, but it is very plausible that the election eventually leads to some market turmoil.  In general, markets prefer boring policies which promise “more of the same,” and we have certainly gotten that for many years.  Congress loves to borrow and spend, the Fed loves to bail out equity weakness with its de facto put, and investors love to extrapolate permanent growth and earnings trajectories when they buy stocks.  

Investors have become so accustomed to central bank intervention to support the stock market at the first signs of trouble, that there were loud cries last week calling for an emergency interest rate cut of fifty basis points.  The fact that the stock markets were still well up for the year when cries for help rang out shows us just how much the market depends on the central bank to bail them out of any sharp market sell-off, however short-lived it might be.  It would have been a major blunder by the Fed to accommodate with this rate cut, and thankfully they resisted the pressure.

Over the coming months, I expect a compression of corporate earnings that should eventually weigh on some of the longer-term equity valuations.  The lofty valuations of many companies will be hurt by this compression, but a possible euphoric reaction by investors to the Fed’s interest rate cut might trigger one more, strong rally, potentially to new highs.  I don’t expect that rally to be sustained.  Rather, I would expect it to be a sort of blow-off top, a last gasp effort of the crazed market bulls to keep the party going prior to a more sustained equity sell-off.  

There are a number of major risks lurking in the shadows, but it is possible that these risks remain hidden for a while longer.  The most obvious issue is whether the Fed can pull off its “soft-landing” scenario.  I maintain that there is a de minimis likelihood of this happening since the real job data suggest we are already in a recession.  It is possible that with enough artificial intervention by the authorities, which would include a massive amount of Fed monetary help and even greater amounts of irresponsible Congressional deficit spending, we might forestall a more serious recession for the time being.  This pattern is consistent with the pattern of the authorities for the past forty-five years, so it is sensible to assume that the people in power will take whatever steps they can to stay in power.  

I will fine-tune some of my forecasts for you over the coming weeks.  As always, wishing you all the very best of luck with your trading.

Andy Krieger