Strong Yen: Curse or Blessing for Retail FX in Japan?

Posted originally on March 29, 2011 at the Aite Group Blog

A complex yet impressive picture of retail FX traders is emerging from Japan. A recent Aite Group report sizes the retail FX market in Japan at 3.6 million, using data from the country’s Financial Futures Association (FFA) and data compiled from almost 40 medium and large retail FX brokers. An estimated 597,000 traders were considered active during Q4 2010.

The relevance of understanding Japanese active-trader patterns resides on the direct correlation that trading volumes and currency pair preferences have with retail FX broker revenue.

The Wall Street Journal recently reported that as much as US$ 171 billion (30%) of US$570 billion traded daily on USDJPY (dollar/yen) can be attributed to Japanese individuals. Without a doubt, the leverage of 50:1 offered to retail traders on their margin deposits plays a big role on how a large number of small traders can have a sizeable impact on the overall market. By contrast, the leverage used by institutional traders is somewhere between 2:1 and 5:1.

The WSJ article was written around the flash crash of sorts experienced in the dollar-yen market on March 16, taking place shortly after 5 p.m., Eastern time (5 a.m. on March 17, Japan time). This is

normally a sleepy time for the market, when the U.S. currency market session ends and passes the invisible baton to Asian session traders. During the incident, the exchange rate dropped from USDJPY 79.58 to a historic low of 77.05 Japanese yen per U.S. dollars within minutes―a very large movement (-3.3% change) for such a short time frame.

The article suggests that Japanese traders (companies and individuals) amassed pending orders, buying the yen against the U.S. dollar in anticipation of a flight-to-safety pattern following bad news from the Fukushima nuclear plant. A set of larger-than-normal orders, it is believed, arrived during this vulnerable time and triggered a flood of “pending” orders (orders than do not become active unless a certain price threshold is reached).

In terms of Japanese retail FX trader behavior, Aite Group sees a very strong direct correlation between the percentage of active retail FX traders and change in USDJPY, particularly in June 2009. As USDJPY rose (i.e., as the yen weakened to the dollar), the number of active traders dropped. In Q1 2009, for example, the U.S. dollar gained 9.5% over Q4 2008, and active traders dropped by 35,000. During Q4 2008, the yen gained 14.5% over Q3 2008, and active traders jumped by 96,000. That relationship is less strong since Q2 2009, in part due to lower volatility in USDJPY and stricter leverage restrictions. The March 11 earthquake changed that, however, and Aite Group expects to see an increase of more than 90,000 new active traders from Q4 2010 to slightly more than 700,000 for Q1 2011.

Aite Group has seen a gradual switch from active trading to more long-term investing in the U.S. dollar. We believe that long-term Japanese traders are increasingly betting that the yen will lose value to the U.S. dollar the more USDJPY drops below a rate of 100. In January 2009, dollar-bullish Japanese retail FX traders were long (bought) US$3.9 billion in USDJPY, and dollar-bearish Japanese traders were short (sold) US$2.8 billion―a 1.5:1 “bullish” ratio. Using the February 2011 data to track the shifting attitudes, we see that the amount of short (sell) USDJPY positions remains steady at US$2.1 billion, but the long (buy) USDJPY positions have risen to US$17.2 billion―an 8:1 bullish ratio.

Comparatively, the bullish ratio for other major currencies (EURJPY, GBPJPY, CADJPY, CHFJPY) averages 1.0, denoting (1) a balance between buyers and sellers for those pairs, and (2) a clear preference of Japanese traders for the U.S. dollar. Growing trends also favor the New Zealand dollar (12:1 bullish ratio) and the South African rand (29:1 bullish ratio). The Australian dollar has also been a favorite of Japanese traders over time, but has currently reached a bullish ratio of 5:1, meaning that it is somewhat less popular than the U.S. dollar.

The Japanese brokerage market has been under immense pressure by tighter spreads on USDJPY and lower trading volume. Aite Group believes that these factors have created a window of opportunity for better-capitalized FX brokers (Japanese or foreign) to gain market share through acquisition. But that window of opportunity may close faster than expected if trading volumes return on the back of USDJPY volatility. This volatility has been on the rise this month due to uncertainty following the massive earthquake, coordinated central bank intervention weakening the yen, and a delicate fiscal outlook for Japan.

Bank of Japan Governor Masaaki Shirakawa was again under pressure last week to exercise extraordinary authority of the central bank and buy back Japanese debt to help fray an estimated US$310 billion of post-earthquake repairs. Shirakawa once more refused, citing difficulty to control inflation once confidence on the yen was lost.

Only last November, Shirakawa was chiding major central banks from the West for assuming that their Keynesian (quantitative easing) policies would result in a quick exit out of a burst-bubble scenario. The Bank of Japan is unlikely to see a change on this position until April 2013, when Shirakawa’s five-year term is set to expire or be reconfirmed.

Thus, the alternative before the Diet of Japan is to issue bonds with or without raising taxes. Most legislators are opposed to raising taxes, but two out of three Japanese voters appear in support of doing so in the current environment. The Japanese debt is now estimated at US$ 12.48 trillion, leaving little room for Japan to raise new debt without having a way to pay for it.

The impasse with Governor Shirakawa will most likely lead to a tug of war between USDJPY bulls and bears, bears using the hawkish posture of the BOJ president as ammunition, bulls citing the need for a weaker yen to heal the Japanese economy. An exchange range between USDJPY 78 to USDJPY 95 could well play out over the next 12 months, providing an incentive to Japanese traders to be active in the FX market and provide a much-needed boost to Japanese retail FX brokers.