Japan: A Disaster on the Horizon?

Unless you have been living under a rock, you would know that the yen has been one of the strongest currencies in the foreign exchange market. The yen has been strongly rallying as of late, and there seems to be no stopping the move.

USD/JPY ChartEUR/JPY Chart
*Click the charts to enlarge*

It’s pretty clear on the charts. Both USD/JPY and EUR/JPY has fallen significantly off their highs, declining 468 and 777 pips respectively. Is this a sign that we should continue to buy the yen? Probably not, as this could all reverse in the next few weeks.

For one, Japan’s preliminary GDP reading for the second quarter of this year was very disappointing. According to the report, although it marked the third straight quarter of expansion, it showed that growth slowed notably.

It revealed that the economy only expanded 0.6%, and not 0.9% as the market had initially predicted. Details of the report showed that business investment was much weaker, and that it was bad enough to counteract the improvements seen in both consumer and government spending.

Now on to my next point – Japan‘s looming tax rate hike.

In about two months, Prime Minister Shinzo Abe will finally decide on whether or not to increase the country’s consumption tax rate from 5% from 8% beginning April of next year. His verdict could very well decide the fate of the Japanese recovery.

Such a hike could deal a major blow to domestic consumption. Take note that in Japan, consumer spending contributes about 60% of the country’s GDP, so any setbacks in that component could dash all hopes for an economic recovery.

But of course, the government also has good reason to implement such a tax hike. If it’s postponed, global debt rating agencies will probably downgrade Japan’s sovereign credit. In turn, this could lead to higher borrowing costs.

Furthermore, a downgrade could also hurt in Japan’s growth strategy and lead to a decline in investor confidence.

No doubt, Abe has a tough decision to make. Some might even say it’s a lose-lose situation.

As with all things forex related, the more important question to us traders is how can we profit from this?

From the looks of it, Japan will be running the gauntlet no matter what it decides to do. And well, the simplest way to short Japan is to short the yen. The government’s ability to intervene in the markets is limited. But keep in mind that Japan prefers a weak yen for import prices to rise and induce inflation.

My bet is that if the tax hike leads to economic problems for the country, the government may get more than it bargained for. That is to say, we could see the yen spiral downwards at a rate that even the Bank of Japan won’t be comfortable with.

USD/JPY Daily Chart

Taking a look at the daily chart of USD/JPY, we see that a rising trend line has formed, with potential support at the 95.00 handle. This talk of the approaching tax hike might just serve as a trigger for another yen sell-off.

But of course, that’s just my opinion. What do you guys think?

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