USD/JPY: Upside Potential over The Next Month?
At around 120 currently, USD/JPY is near the high end of its six year trading range of between 75.81 and 121.544. In contrast with the other majors, it has held up against the US dollar this year -
As shown below, the volatility of the USD/JPY exchange rate has been more constant than that of the dollar index, and has fallen below the index volatility this year. This is consistent with this year’s flat performance of USD/JPY vs significant increase in the index.
We have developed a fair value of the USD/JPY exchange rate based on a multiple regression analysis of its price on 22 driver variables including interest rates, stock indices, commodities and other exchange rates. The database is six years of daily prices.
The elasticity of the USD/JPY fair value to groups of driver variables is shown in the graph below.
The graph at the beginning of this article above shows that JPY’s recent moves against the USD have been less than the dollar index. However, the above graph shows that over the six year analysis period, USD/JPY has moved in the same direction as, but by more than, the dollar index.
We have also developed a prediction model based on the lead given by the change in the Baltic Dry Index (BDI) of raw material shipping freight rates. This index is widely seen as a leading indicator of world economic growth, with increases viewed as bullish and conversely.
Based on the BDI lead, it is possible to develop price predictions for a range of commodities, interest rates, stock indices and currencies. These can be combined with the fair value model elasticities shown above to give a predicted movement in the USD/JPY exchange rate over the next week and month. We also back test the prediction models to assess their value in a trading environment (taking a long position when the predicted price change is positive and a short position when negative).
The predicted price changes for the next week and month, and the annualized return/volatility ratio over the last six years from trading the predictions, are shown in the following table –
The return/volatility from trading all the predictions combined (of around 160%) compares with that applying to the S&P 500 over the same period, of 102.2%. We consider this to be reasonably robust given the period commences in mid-2009, around the start of the latest bull market in US stocks.
Our predicted movement in the USD/JPY price for the next week and month is shown in the table below. The contribution of each driver variable to the overall decrease is also shown.
As can be seen from the above two tables, our positive view on the US dollar plays heavily into our positive view on USD/JPY.
We also used the BDI model to directly forecast the USD/JPY price movement for the next week and month. Changes of +0.4% (week) and +3.0% (month) resulted, confirming the signals given above. The six year back test return/volatility ratios from trading these models were both around 80%.
Allocating a component of a US stock portfolio tracking the S&P 500 to USD/JPY traded using the BDI leading indicator as outlined in this article for one-month holding periods would have improved the return/volatility ratio of the portfolio. For a 5% allocation, the ratio would have improved from 102.2% to 105.3% for the last six years.