AR-YEN traded significantly higher last week, as the Bank of Japan surprised the markets with more QE. As we have seen on many other occasions, when a central bank decides to ease monetary policy, the country’s currency tends to weaken. Dollar-yen is 4.5 per cent higher than on Friday last week.
It’s hard to know how much weaker the yen might trade, but the most optimistic forecasts are expecting dollar-yen to reach ¥116 by the end of the first quarter of 2015.
As it’s hard to know exactly what might happen with a currency pair, it’s worth looking at other markets. To help us with our trading, we can take clues from the Nikkei 225, the Japanese stock index. While the Japanese stock market only describes 50 per cent of the weekly range of dollar-yen, the weekly correlation is even higher. The directional correlation is +0.70, which means that, if the Nikkei 225 trades 1 per cent higher, dollar-yen should trade 0.7 per cent higher. Knowing this is great as it allows us to enter trades with greater certainty that the move we estimate will be correct. If it isn’t, both FX and stock market traders must be wrong.
Another market FX traders watch is the yield on US 10-year bonds, which also show a positive correlation with dollar-yen. The rationale is that Bank of Japan QE will keep Japanese interest rates low, discouraging capital flows to Japan. The US, meanwhile, which has strong GDP growth and a central bank that wants to increase yields, should experience an inflow of capital.
Alejandro Zambrano is a currency strategy analyst at DailyFX.com. He leads a monthly educational seminar for FXCM live clients at http://bit.ly/PremiumEDU