- EUR/JPY did extremely well in 2017 following Macron's victory in French presidential elections
- Despite ongoing global boom, case for long EUR/JPY is weaker today
- Rising long euro and short yen positions a risk, BoJ tightening another issue
In early 2017, doubts regarding the integrity of the Eurozone led many to take refuge in the Japanese yen. Unlike the euro, the Japanese yen exhibits classic safe haven characteristics and tends to strengthen during downturns. Following the Brexit referendum vote and US presidential elections, few were willing to bet on opinion polls that predicted Macron’s victory. Similar to political events in 2016, there was a risk that polls were failing to capture the so-called protest vote. Following the Eurozone crisis, French GDP growth remained weak, while disappointment with the European Union was growing. Given the risk of a future French president ideologically opposed to the European Union, EUR/JPY weakened as investors hedged their long euro positions.
Long euros now a global consensus
Following the victory of Emmanuel Macron and a strong rebound in Eurozone growth, investors unwound their hedges and went long the euro. Unsurprisingly, EUR/JPY soared in response. Looking at data from the Commitments of Traders report, euro speculators flipped from net short to net long soon after Macron’s victory in May 2017. Over the course of 2017 and early 2018, euro net long positions have continued to build. This is visually shown below:
Euro long positions, and positions as a proportion of open interest at extremes
As can be seen above, the number of net long positions in euro futures and options contracts has continued to grow since May 2017 and currently stands at +143,097 contracts. As we wrote in our latest commentary on the COT Report, long euros is at a bullish extreme (more than two standard deviations above trailing averages) looking at the last 36 months of data. Finally, long interest is also fairly high as a proportion of total open interest. Specifically, the net long position is 20.1% of all open interest. Looking at technical conditions, we have warned that the euro is looking overbought in several editions of our euro daily update.
While speculator sentiment looks extreme, the longer term bull case for the euro remains intact. Economic data points to continued GDP growth (manufacturing PMIs announced earlier today remain at multi-year highs), while monetary tightening expectations are also helping. Although the European Central Bank has pointed out weak inflation as an issue, it is running out of excuses to maintain its asset buying program. As such, the ECB is more likely to end quantitative easing in the second half of the year, helping the euro
All clear to short the yen?
Looking at the yen, the case for future yen weakness seems clear at first glance. Unlike speculator positioning on the euro, yen positioning based on trailing 36-month averages is not yet at an extreme. Thanks to rising global bond yields (a result of accelerating inflation), the yen should stay weak as long as the Bank of Japan’s yield curve control program stays in place. Today, the BoJ buys and sells Japanese government bonds such that 10-year yields are fixed at “around” 0%. Furthermore, the yen tends to weaken during global booms, and we’re clearly in the middle of one today. In short, prevailing economic conditions should result in a weaker yen.
Bank of Japan tweaks + consensus short a real risk
Unfortunately, the seemingly clear-cut short yen trade runs into trouble when looking at the Bank of Japan’s latest actions and speculator positioning. Looking at Commitments of Traders data, short yen net positions have been fairly large in recent history, thus positioning does not initially look extreme based on 36-month trailing averages. The issue is that open interest in the yen is fairly small today. As a proportion of open interest, net short positions account for 46% of the total. This is shown below:
Consensus is shorting the yen
As can be seen above, the short yen position is fairly significant as a proportion of open interest. The last time this occurred in late July 2017, the yen strengthened and speculators dumped their short positions.
Turning to monetary policy, Bank of Japan Governor Kuroda spooked yen traders when he recently spoke of “reversal rates”. The reversal rate is the idea that the economy suffers when interest rates are too low. At a certain point (the reversal rate), banks stop lending as the activity becomes unprofitable. Following his discussion of the idea, the yen strengthened as traders bet on tighter monetary policy.
More recently, the Bank of Japan reduced its purchases of long-dated Japanese government bonds. This was another sign that the BoJ may be looking to make changes. The yen strengthened sharply in response. Following the move, both our short-term and medium-term trending indicators now suggest the yen is set to strengthen in the near future. In a recent commentary on Japanese monetary policy, we argue that the yen’s recent strength seems somewhat premature. While yield curve control will ultimately undergo changes, the BoJ is not expected to rock the boat. As monetary easing is a core component of Abenomics, Kuroda is unlikely to voluntarily bring about yen strength.
EUR/JPY: no longer a no-brainer
As sentiment towards the euro hits bullish extremes while short yen becomes a consensus favorite, long EUR/JPY is a much tougher trade to execute. While the Bank of Japan has been reliably biased towards easing since Abe became the country’s prime minister, potential adjustments to yield curve control are a real risk. As such, the long case for long EUR/JPY is much trickier today.