Copyright (c) 2012 Trend Following 101

The most startling development in currencies for 2012 is the move weaker in the USDJPY and FXY.

The move-weaker for the yen was sudden, shocking and happened over a period of just 6 weeks. The Bank of Japan announced a new inflation target of 1%-this was a startling move because Japan had targeted zero inflation for decades.

The yen responded with a huge, one-way move and lost almost 1% per week. Then the fall came to a dead stop on March 14th.

The USDJPY has now been waffling back and forth since March 14th. Why did it stop after such a dramatic move? There is one major reason for this: China was unhappy with the pace of the weakness in the USDJPY.

You'll see why when we recap the important news of the last few months.

Japan announced an inflation target of 1% on February 14th.
Then Japan and China announce a deal to resolve Chinese debt on March 14th.
On February 14th, the Bank of Japan shocked nearly everyone* with an announcement it was shifting the inflation target from 0% to 1%. (*This did not shock everyone. Look at a chart of the yen. The move up started on Feb. 2nd, before the announcement. The yen went straight up for 10 days. This announcement was leaked.)

Then on March 14th, Japan announces they reached an agreement with China to buy Chinese government bonds. This should be further weakness for the yen but strangely enough, March 14th was the low for the yen against the U.S. Dollar.

Here is the problem: These announcements and deals were too successful given the current economic situation in China. The agreement weakened the USDJPY too quickly.

China faces an economic slowdown, and does not want to end up with low growth and the unhappy citizens low growth brings with it. The solution to that "problem" is to slow down the fall in the value of the Yen. And that's what happened.

It's good to remember the USDCNY exchange rate is managed by China every day. The Yuan has a floating peg against the U.S. Dollar. China allows some growth in the value of the CNY, but the changes in the value of the USDCNY are tiny compared to free floating currencies like the USDJPY.

This means if the U.S. Dollar gets stronger against another currency, the Chinese Yuan gets stronger too. If the Yen falls in value against the U.S. Dollar, it's also falling against the Yuan.

China uses exchange rates as a major policy tool for boosting growth or slowing inflation. The last few weeks provided some indication China faces an economic slowdown and here they are:

China Slowdown is No Cause for Alarm
China lowered growth forecast to 7.5%
Stocks lower on worries over China slowdown

China is clearly slowing growth just a bit. They would typically respond to economic slowdown by slowing the rise in the value of the Yuan.

The fall in value of the JPY was expected, in my opinion, but the speed in which it happened was just too much, too soon for China. The initial fall in the USDJPY was expected by China, but now we know where the USDJPY becomes "too weak" for China. It's 84.15 USDJPY.

At 84.15, the USDJPY is very close to the weakest levels it has been in for the last 18 months. China is worried about their growth slowing, so adding the pressure of increased price competition from Japan is not something China wants right now.

This is not to say the USDJPY can't or won't go higher (meaning the Japanese yen can get weaker against the USD). There is plenty of room for more weakness in the yen against the USD and the EUR due to the new commitment to a 1% inflation rate.

In fact, there is a flag formation in the USDJPY, and this formation gives a target of at least 86.50. On the weekly chart, the formation gives a target of nearly 90.00

Nevertheless, keep in mind that China prefers moderation in exchange-rate level changes, and they are facing an economic slowdown. Even if the yen does weaken in value, China will probably "increase their reserves of Japanese yen at attractive prices". So while the USDJPY might rally more (implying a fall in the value of the yen) China will not want this to happen either too quickly or with a high level of volatility.