A Near-Term Correction Lower In USD/JPY Looks Imminent

This week USD/JPY stands out and currently looks significantly overbought. We expect further weakening of JPY over the coming 6-12 months and we still prefer to buy USD/JPY on dips. However, there are several factors suggesting that the recent spike in USD/JPY currently looks excessive and indicate that a short-term correction could be imminent. Hence, we suggest utilizing a possible correction lower in USD/JPY by buying a 1M USD/JPY 82.50 KI call option with barrier at 81.75.

What stands out
Looking at the signals from our short-term financial models, JPY and CZK stand out. Both currencies have depreciated considerably over the past weeks as the market has been pricing in a higher probability of further central bank easing. According to our short-term models USD/JPY is currently trading with the biggest misalignment (2.1 standard deviation above model estimate) and looks significantly overbought. EUR/JPY and EUR/CZK are also trading with significant misalignments versus models estimates, and we still recommend being long USD/JPY and EUR/CZK, even though our models are unable to explain the current misalignments.

In particular, we see a strong case for a considerably weaker yen as an economic recession and the forthcoming general election in Japan have raised speculations of an increase of the BoJ’s inflation target from the current 1% to 3%. If a credible higher inflation target is introduced, it could prompt a structural shift in the underlying appreciation trend of recent decades and thus pave the way for a significant weakening of the yen.

However, there are several factors suggesting that the recent spike in USD/JPY currently looks excessive and indicates that a short-term correction could be imminent. First, USD/JPY, as mentioned earlier, is significantly overbought according to our short-term financial model. Second, the RSI index has reached levels above 70 (currently 79), which also implies that USD/JPY is overbought. Finally, investors are already net long USD/JPY, according to the latest IMM data. Hence, there are many indications that the recent move higher has been a bit too fast.

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