Forget the Fed, Sell Euro Buy Yen Is Answer to Divergence Trade

  • Forecasts call for more ECB bond-buying while BOJ stays put
  • SocGen sees Europe's shared currency weakening to 126 yen

The policy-divergence trade is back -- just not the one currency markets have been waiting for.

The euro-dollar trade that dominated foreign-exchange markets last year and for the first part of 2015 is looking exhausted, with the prospect of the Federal Reserve raising interest rates already reflected in the greenback’s value. The best way to profit from differences in central banks’ monetary policies is to sell euros and buy yen, according to Nomura Holdings Inc. and Societe Generale SA.

They’re betting the European Central Bank will boost its stimulus program while its Tokyo-based counterpart stands pat -- an expectation that’s reflected in the biggest gap in interest-rate swaps denominated in the euro and yen since the euro’s 1999 debut. The shared currency touched a six-month low versus the yen last week.

“There’s more room for euro depreciation against the yen than the dollar,” said Olivier Korber, a Paris-based strategist at SocGen. “The dollar has already priced in the new Fed rate expectations, while Draghi has been consistent in saying there will be more policy action, and the Bank of Japan’s lack of action means there is no catalyst for a weaker yen.”

It’s just the latest example of how central banks are driving markets. The euro slid to its lowest since April versus the yen after BOJ Governor Haruhiko Kuroda decided last week against stepping up the central bank’s monetary stimulus. That was one week after Mario Draghi signaled he may expand the ECB’s quantitative-easing program before year-end.  

Fed officials did indicate last month they were on course to start tightening this year, yet their data-dependent stance means policy is contingent on how economic reports pan out before they gather next month.

Technical Target

SocGen, using trading patterns to determine future prices, sees the euro weakening to 126 yen within two to three months. The bank’s strategists recommend an option strategy that involves purchasing euro puts, which profit if the common currency declines versus yen, and simultaneously selling euro calls to offset the costs of the options purchased.

The shared currency was worth 132.71 yen as of 1:07 p.m. New York time, up from a low of 131.60 reached on Oct. 29. 

The two-year interest-rate swap rate denominated in euros is at negative 0.02 percent, 0.13 percentage point less than similar yen-based rates. The spread between the two, used by traders as a key barometer of relative currency valuations, has collapsed to its least since 1999.

Market Signal

“Euro-yen is looking like a pretty good bet to short for the remainder of the year, given the policy outlook between the ECB, which is signaling more easing, and the BOJ, which signaled it won’t be any time in the very near future,” said Omer Esiner, chief market analyst at currency brokerage Commonwealth Foreign Exchange Inc. in Washington.

Fed policy makers said Oct. 28 they’ll consider tightening policy at their next meeting in December, without making a commitment to act this year, as the economy continues to expand at a “moderate” pace. Traders in U.S. futures still the chances of a rate increase later this year as little more than a coin flip, according to data compiled by Bloomberg.

"I’d still prefer short euro-dollar to short euro-yen,” said Shahab Jalinoos, global head of foreign-exchange strategy in New York at Credit Suisse Group AG. “The Fed still has on the table the possibility of a rate hike this year. That’s something definitely not fully priced in." 

The demand for contracts that profit if the euro weakens versus the yen, relative to those that gain on the common currency’s upside, has been little changed the past month. Risk-reversals for three-month options show a 1 percentage-point premium to purchase euro puts compared with calls, still less than a peak in 2015 of 2.75 percentage points in February.

In an Oct. 30 note to clients, Nomura’s foreign-exchange team said they see “more meaningful downside in the euro-yen.”

“There are a lot of people out there looking to short the euro-yen,” said Charles St-Arnaud, a senior economist at Nomura in London. “You’re playing the policy divergence.”

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