Bearish on USDJPY, bullish on gold and silver

*Our fund only trades the S&P 500, while our sister fund solely trades silver. We only use our quantitative models while they combine models with a discretionary approach. Here are their thoughts on currencies, gold and silver.
There is an extremely strong inverse correlation between USDJPY and gold. It’s -0.9! This inverse correlation began in 2002, and has become exceptionally strong since 2009. Most of USDJPY’s medium term peaks = gold’s medium term bottoms, and most of USDJPY’s medium term bottoms = gold’s medium term peaks.
Here is a chart for USDJPY that’s overlapped with gold. (USDJPY is black, gold is red).

We have no idea why this correlation exists. Some traders say “that’s because the Yen and gold are both safety haven assets”. Honestly, that explanation sounds like a load of BS. Gold tanked in 2008 during the worst of the financial crisis. Other traders attribute this correlation to central bank manipulation. We disagree with conspiracy theorists. Central banks have better things to do than manipulate the price of gold on a day-to-day basis. Their fiat currencies aren’t even tied to gold, so why should they care?
We usually ignore correlations that have no fundamental reasons behind them. Correlations work until they break, and you have no idea when the correlation will break.
However, this correlation is too strong to ignore.

  1. This correlation isn’t a flavor-of-the-month phenomenon. It’s been going on for 15 years.
  2. It’s not just the medium term high/lows that are correlated. There is an insanely strong day-to-day inverse correlation as well.

*The Yen-gold correlation is much stronger than the Euro-gold correlation. That’s why the USD Index-gold correlation isn’t extremely strong (57% of the USD Index is Euro).

95% of retail traders are bullish on USDJPY…

Gold has been sinking recently while USDJPY has rallied. The inverse correlation is astonishing.
Here’s gold.

Here’s USDJPY.

We talk to a lot of independent currency traders (around 40-50), and 95% of them are bullish on USDJPY right now. What’s even more surprising is that they’re all bullish for the exact same reasons.

  1. “The USDJPY is about to breakout from its major trendline resistance”.
  2. “The Bank of Japan is doing infinite QE. Hence the USDJPY’s fundamentals are bullish”.

We disagree with both of these points.

  1. Support/resistance breakout/breakdowns don’t work that well. Nowadays, there are too many false breakout/breakdowns. Traders who use this strategy have an edge that’s barely greater than 50-50.
  2. QE isn’t necessarily bearish for the Yen and bullish for USDJPY. The Federal Reserve did multiple rounds of QE from 2011 to 2013, and the USD actually went up a little!

We’d like to explain that second point in detail.
The second point
Here’s why 99% of forex traders rely mainly on technical analysis, whereas only 50% of stock market traders rely mainly on technical analysis:

  1. In the U.S. stock market, the fundamentals determine the market’s medium-long term direction. The U.S. stock market’s fundamentals are extremely easy to understand. An improving U.S. economy = U.S. stock market up. A deteriorating U.S. economy = U.S. stock market down. That’s what our medium-long term model is based on.
  2. Fundamentals in forex are extremely complicated and hard to understand. Most traders are terrible at understanding fundamentals because they don’t spend enough time analyzing the fundamentals!

The fundamentals of a currency pair is governed by one concept: money flow. Money flow is the fundamental demand for that currency. E.g. when there are bigger profit opportunities in Japan, money will flow towards Japan and USDJPY will go down.
Economics majors are taught that when interest rates go up, the country’s currency appreciates, ceteris paribus. The second part of that statement – “ceteris paribus” – is why the statement is only right half of the time.
For example, the Fed hiked rates like crazy from 2004-2006. The US Dollar fell.
This is because rate hikes/cuts are only one factor of “money flow”. Not all money flows are due to interest rate differentials. There are other factors that are much more important in “money flow”, such as

  1. Corporate profit opportunities.
  2. The speed of an economy’s recovery.

Right now, global money flow is moving away from the USD. Hence, we think the Euro is in a bull market. Since the Euro accounts 57% of the USD Index, this means that the USD Index is in a bear market. It is not possible for the USD to be in a big bear market while the USDJPY is in a big bull market. EURUSD’s bull market will eventually drag the USDJPY down.
Meanwhile, Japan’s fundamentals are improving.

The fact that the BoJ needs to do infinite QE because Japanese long term rates are rising tells you that market forces are pushing rates higher.
Central banks can go against market forces for a while (i.e. a few months), but they cannot do so forever. Many investors/traders fail to realize this point. It’s not “don’t fight the central banks”. It’s “don’t fight the market”. The market is ultimately bigger than ANY institution.
Bernake could keep rates artificially low from 2009-2013 because U.S. fundamentals allowed him to do so. The U.S. economic recovery was sufficiently weak. When the U.S. economy improved to a certain point, Bernake had no choice but to stop QE. When the U.S. economy improved to a specific point, Yellen had no choice but to start hiking rates. Market forces drive the Fed, not the other way around. The same will be true for Japan.
If the central bank could always have its way, there would never be a recession again. We know there will ALWAYS be recessions. Likewise, the BoJ cannot keep Japanese rates down forever, especially as Japan’s economic recovery picks up.
Price action
If these traders are right – if the USDJPY is going higher because the BoJ announced infinite QE – why did USDJPY go up a mere 1.5 this week? If the USDJPY really is in a bull market, it should have SOARED on this news!
In other words, USDJPY’s price action is bearish. The BoJ is out of bullets. After announcing infinite QE, the BoJ has nothing left to do. There is nothing left that can cause USDJPY to surge.

Back to “95% of traders are bullish on USDJPY”

Being contrarian just for the sake of being contrarian is how you get wiped out.

  1. When it’s the middle of a bull market and “95% of traders are bullish”, shorting the market will get you killed. The majority are right in bull markets.
  2. When it’s a bear market / big consolidation and “95% of traders are bullish”, it’s a good time to short. The majority tend to be dead wrong in bear markets.

The only way that “95% of traders” can be right about USDJPY is if the USD is still in a massive bullish market. The USD Index is in a bear market right now. The USD Index is determined by the Euro, not the Yen.
In order for the USD Index to still be in a bull market, the USD has to breakout from its 103.81 resistance. That’s way too far! The USD Index is currently at 95.79. Last year, the USD needed the MASSIVE Trump “theme” to push the USD up from 96 to 103. The Trump theme is dying right now. There is no theme today that can push the USD up that much!

Price action
Think the Federal Reserve’s rate hikes will push the USD higher? Think again. As you can see in the chart below, all of the Fed’s rate hikes failed to push the USD higher in the medium term.

The ECB is on a path towards monetary tightening because Europe’s economy is improving. The USD’s price action is clearly bearish.

Bottom line

We think the USDJPY is in a bear market because the USD Index is in a bear market. Based on the extremely strong inverse correlation between USDJPY and gold, we think USDJPY is making a top and gold is making a bottom.
In addition, there are some long term extreme BUY signals for gold and silver.
*These are our sister fund’s thoughts. We neither agree nor disagree because we don’t trade forex/precious metals. Our sister fund only cares about USDJPY to the extent that it impacts gold/silver.

1 comment add yours

  1. Correct conclusion, wrong reasoning. I dont think that the USD/JPY is in a bear market because the USINDEX is in a bear market. First of all there is no technical confirmation yet that the USINDEX is in a bear market. We need to have at least monthly reaction and the price to take out the base of the reaction. Second even if we are in a bear market ( so that we will not see any break of 103 in the medium term) the USD JPY will not go down just because of this. Just see what the USD JPY was doing during the recent dark days of the USD (2012-2014) where the USD was getting beaten by the EURO and still was making higher highs against the JPY. The USDJPY still may go down for different reasons as could be a medium term mini crash on stock market, to clear the sentiment for the big move ahead.

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