Trade with the Central Banks

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By Shavasb Bohdjalian

The ECB delivered on the 25bps hike as expected last week, but our expectation that a classic “buy the rumour, sell the fact” situation would arise was brushed aside after ECB President Jean Claude Trichet stated that the ECB would closely monitor developments on inflation, leaving the impression that more rate increases would be forthcoming during the year.
In addition, he explained that the ECB will ensure that inflation expectations are firmly anchored. But the bigger picture is that regardless of the speed of hikes, the ECB has made it clear that they will act early and decisively to address inflationary concerns.
The bailout for Portugal has been shrugged off by a market that has long anticipated it; and it will remain a sideshow for the EUR as long as there is no contagion into Spain. Asian central banks have been extremely active, and with oil prices moving higher once again, analysts at BNP Paribas expect further forex reserve diversification to push EUR yet higher. The break of 1.4375 now opens up the way for a move to a new target of 1.4500.
On the other hand, the Bank of Japan policy meeting reaffirmed the weak economic situation in Japan and promised to keep its loose monetary policy in place. As Chief Currency Strategist at UBS Investment Bank noted, the ultra-loose monetary situation combined with the G7 coordinated intervention in favour of weakening the yen have near convinced all analysts that the yen has to weaken and will likely be used as a carry trade.
A carry trade is when investors borrow in a low yielding currency – in this case the yen- to fund investments in higher yielding assets elsewhere. Also supporting the carry trade is Japan’s low interest rates, which UBS expects will continue for a "very long period" of time, possibly through 2013. And as other central banks start to raise rates, Japanese investors will see more value in buying higher yielding foreign assets.
This dynamic will keep the yen weak against the dollar for the next one and a half years at least, UBS added. "We now see dollar-yen ending this year at 90, and then that rate rising to 100 at the end of 2012."
The same sentiment was echoed by Morgan Stanley, which in a note to clients recommended to establish long EUR/short JPY positions at 122 for target 130 and with stop loss protection at 118.80.
With the ECB stating clearly that it will act decisively to control inflation – meaning increasing rates – and the BoJ promising to flood the market with cheap money for an extended period – the prospects of the euro and other high yield currencies including the Australian dollar appreciating against the yen is now backed by both fundamentals as well as technical indicators.
All major currencies (including the dollar) have clearly broken above their 200-day moving averages against the yen which clearly indicates that the trend is for general yen weakness. Although on the short term the yen is over-sold and may consolidate at current prices or even stage a small correction, but such corrections will most likely be used by investors to sell more yen.
Without a doubt, the best way for the devastated Japanese institutions to recoup most of the losses sustained from the tsunami, the earthquake and the nuclear accident is to hold on to their foreign assets and transfer more assets abroad. And a foreign investor would be stupid to leave other economies and invest in Japan.
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