USD/JPY Forecast: ‘Reflation trade’ is overbought, correction likely

The reflation trade has pushed all three major US indices - Dow, Nasdaq, and S&P 500 to record highs, pushed the US dollar index to the highest since April 2003 and led to a sell-off in the bonds and safe haven assets like gold.

The Reflation trade is on ever since Donald Trump won the US Presidential Elections. Investors expect Trump to deliver on his pre election promises - cut corporation tax, ‘spend till end’, boost infrastructure spending, bring jobs back to America…

The base metals rallied as well on hopes the increased infrastructure spending in the US would boost demand.

‘Hope Trade’

• The USD/JPY pair has rallied from 101.16 (Election Day low) to 111.36 (Nov 21 high).
• Dow 30 index has rallied from 18,250 (Election Day low) to 19,043 (Nov 22 high).

In past, the reflation trade i.e. the drop in the Japanese Yen and the rise in the US stocks was the result of Bank of Japan’s aggressive monetary easing.

This time it is the ‘Trump Trade’ that is driving the Yen lower and the US stocks higher. Prospect of a cut in the corporation tax from 30% to 15% coupled with an increase in the infrastructure spending is too exciting for the stock market bulls.

However, the entire rally from the Election Day low is a ‘hope trade’. Donald Trump is yet to take office and there is every possibility that he may fall short of the market expectations. Furthermore, Trump has announced that he plans to scrap the TPP agreement on the first day in office. This is likely to heighten the fears of trade wars/protectionism.

USD/JPY is overbought

Daily chart - USD/JPY (Candles) & Dow (blue line)

• The Dollar-Yen pair and the Dow index have moved hand in hand since the Election Day.
• The daily MACD clearly shows the loss of the bullish momentum in the USD/JPY pair.
• The daily RSI too is overbought and is on the verge of forming a bearish divergence with the price chart.

Dow Daily chart

The daily RSI is overbought and the MACD is showing the loss of bullish momentum.

To conclude - The overbought status of the Dow 30 index adds credence to the overbought conditions in the USD/JPY pair and suggests potential for a correction in the reflation trade. Consequently, it is safer to assume the Dollar-Yen pair is likely to witness a pull back to 1110.-109.00 levels in the short-term.