The Yen Long Thesis

An edge in trading requires an edge in vision, strategy, and execution. The framework that allows me to find my trades is known as the theory of reflexivity, and it was created and implemented by George Soros. This theory has in its core the principle that the perception of reality is more important than reality itself, and that participants' biases create boom and bust cycles that feed on themselves, creating a reflexive feedback loop. Therefore, a successful vision requires recognizing the driver of perception in a cycle, discounting the obvious and betting on the unexpected.

Throughout October, the consensus market participant view was that long-term U.S. treasury yields should be higher to reflect both the unsustainable U.S. fiscal deficit condition and that there are supply and demand imbalances in the Treasury market. What participants failed to see, and still do, is the reality that the easiest way to reduce the fiscal deficit is to reduce the biggest expense, which is interest. Also, there is no demand imbalance when there is a buyer of last resort. The reason why most participants do not yet see this view is based on their personal belief on what the Federal Reserve is and should do, instead of what has the Federal Reserve done in the last twenty years and what they are likely to do next.? In my upcoming Timestrat publication, “Higher for Now, Lower Forever,” I will cover and explore in detail this boom and bust cycle.

Considering that I had identified an ending bust cycle, my goal was to find the most duration sensitive investment vehicle to take advantage of. I decided that based on seasonality (the end of October to November has the biggest rate of change in sentiment) the instrument I should choose was options. Since I chose options, my goal was to find a security where realized volatility would be likely greater than implied volatility given the historical conditions while also providing an attractive delta to entry cost ratio. Given these circumstances, I backtested the options screening and found trading currencies the solution.

Furthermore, I supplement my vision with technical analysis, and quantitative implied volatility models. For me, there must be a confluence between the systems that influence my decision-making to ensure an edge. From a technical perspective, at that time the USD/JPY was testing its prior high it set when this pair topped in October 2022. More importantly, this level was a test of a horizontal resistance trendline that has existed since 1989, it was doubtful for the dollar to break out without a massive catalyst

Moreover, there were considerable negative divergences relative to this pair. For example, the U.S. 2 year - 30 year treasury spread was considerably wider than when it was when the pair topped. While interest rates differentials were larger, the Yen was showing relative strength.

Another negative divergence was that while the pair reached the same level, the relative strength and momentum were setting in lower highs, giving me another reason to be bullish on the Yen.

Like the technical analysis, the implied volatility models I used signaled that the risk/reversal was to the market's advantage. We had already reached the “sticky” damaging strikes for the major indices, and dealer inventory was at a record level for negative gamma. Additionally, the term structure for implied volatility models showed me that implied volatility across calls and puts sharply declined for other expirations. This combination of factors gave me confidence that the downside was already priced in, and the risk participants were ignoring was a face-ripping rally that nobody was positioned for. For me, the cherry on the top for confirmation was that CTAs and leveraged macro funds were near records short of the Yen with a fairy tale mentality of the FEDs higher for longer.

Looking forward, it is likely that this dynamic will continue into 2024. Usually, after an outsized move like the one we experienced, there is consolidation and continuation.

The drivers for lower interest rate differentials between the U.S. and Japan are here to stay. Not only are global PMIs decelerating across the world, but the unemployment rate in the United States is steadily increasing. As the business cycle slows into a pre-election year, the political pressure to lower rates in the United States increases. While 75 bps of FED Funds Futures cuts are being priced in, it is likely that the FED will resort to a more extreme approach toward rate cuts in the case of a hard landing.