EUR/JPY: No longer a barometer of risk-on rallies, a long-term sell

Since the 2008 crisis, the EUR/JPY was widely tracked as it was the barometer of risk-on rallies across the global markets. EUR being the ultimate growth currency, while JPY, a traditional safe haven asset. Hence, rise in EUR/JPY was a sign of increasing risk appetite across the board and vice versa.

However, the pair no longer serves as a barometer of risk-on sentiment. Before listing the reasons for the same it is worth looking at the chart showing a comparison between the EUR/JPY and Dow Jones.

As we can see the DJIA and EUR/JPY had a strong direct relationship up until the last quarter of 2014.

• From Dec 2012 (beginning of Fed’s open ended QE), the DJIA has rallied from 13000 to 18000, while the EUR/JPY rallied from 110.00 to 150.00

• The Japanese Yen had started falling rapidly from Oct-Nov 2012 as newly elected PM Abe called for aggressive monetary policy easing, which was finally announced in April 2013.

• So we had the QE from the BOJ as well from the Fed, which led to a sharp rally in the EUR and weakness in the JPY. Though, the EU had just sustained debt crisis, it was still far from being a funding currency and the ECB was relatively hawkish back then.

• Hence, the EUR/JPY acted as a barometer for market sentiment. The rally in DJIA – risk asset – was accompanied by a similar rally in the EUR/JPY.

EUR/JPY – no longer a barometer of risk-on/risk-off sentiment

EUR is a funding currency, but not a safe haven – The Euro is not longer a growth currency. With the Refi rate at 0.05% and the deposit rate at -0.20% it is now a funding currency. The ECB’s QE led drop in German long term bond yields to near zero levels means the investors have to look out for other high yielding assets outside the Eurozone. This is nothing but Draghi’s portfolio adjustment effect. However, the search for yield is high during risk-on rallies. Hence, the EUR is likely to be sold now during risk-on rallies in the markets.

However, that does not mean the shared currency would be preferred in times of risk-off rallies. Though a funding currency, it is still not a safe haven asset. With Greece issue and debt problems the currency is likely to be a last resort - below Treasuries, Gold, Japanese Yen and Swiss franc in times of risk-off.

Consequently, the pair does not represent a risk-on/risk-off as accurately as it did earlier. It is clear from the chart above that the strong direct correlation does not exist now.

So which currency/currency pair takes up EUR/JPY’s role?

In my opinion, the USD and/or GBP are the risk currencies now. Since both countries are expected to hike rates this year or next year, the markets are likely to associate them with growth and risk-on rallies. Apart from the USD and GBP, most other currencies are now funding currencies since the majority of their central bankers are at the zero lower bound or expected to hit the zero lower bound soon.

The US Treasuries, Gold, Japanese Yen, Swiss Franc and German bunds are likely to benefit from risk-off rallies on safe haven appeal. In my opinion. Gold is likely to be the biggest beneficiary of risk-off event, followed by the Japanese Yen and Treasuries. The USD is likely to act both as a risk currency as well as safe haven due to the appeal of treasuries. However, Gold, Swiss Franc and Japanese Yen would overshadow USD as safe haven assets.

So it is unlikely that we have a particular currency pair which would represent a risk-on/risk-off the way EUR/JPY did earlier.

The net impact is the EUR/JPY remains a long term sell as –

1. It is a funding currency but a relatively less attractive safe haven asset. Consequently, it would under perform in times of risk aversion.

1. German 10-year yield (at 0.10%) now trades below Japanese 10-year yield (at 0.30%). With the ECB’s QE program expected to continue till September 2016, the German yields could only extend losses. On the other hand, markets have started speculating BOJ QQE taper next year. Thus, the Japanese yield could harden. Therefore, investors in the Eurozone could even look for Japanese assets due to worsening German-Japanese yield spread.

1. The chart above shows the risk-on rally from the last quarter of 2012 was largely driven by funding currencies – JPY.

1. However, with risk assets at overbought levels and every major currency being stuck at the zero lower bound, the onus of supporting risk assets/risk-on rallies falls on economic growth, mainly in the US. Given, the US is showing signs of weakness, the rate hike could be delayed, which would be a risk-off event too.

1. Consequently, JPY stands to be the biggest gainer, and EUR/JPY a major loser in case of risk aversion

The pair could see technical rallies up to 133.136 levels from the current level of 129.00 in case the EUR rebounds due to the unwinding of over stretched short positions. However, the pair is likely to decline to its 200-week average at 122.74 and may even extend losses to 118.73 levels by August-September 2015.