Next up, Currency crisis

Stephen Jen, the chief currency strategist at Morgan Stanley, wrote in a recent report that since the fall of Lehman, we’ve been seeing clear signs of currency crises throughout the world of emerging markets, including Eastern Europe. This time, it’s not an Asian crisis or a Latin American crisis, it’s a global crisis. He adds that "So far,the US financial sector has been the epicentre of the global crisis. I fear that a hard landing in EM assets and economies will become the second epicentre in the coming months, with very damaging feedback effects on the developed world." Yves Smith of Naked Capitalism has a very good post on the same subject, entitled "Currency Crisis is a gathering storm".

The current global deleveraging exercise has resulted in all class of assets being sold off & the proceed repatriated back to the US to meet mounting funds redemption or to lower the liabilities side of over-leveraged US financial companies. This led to a sharp rise in the US Dollar (USD). Some of this proceed would have flowed back to the other great provider of credit, Japan. This in turn has led to a rise in Japanese Yen (JPY). The latter could have triggered an unwinding of the yen carry trade, which might have reached a self-sustaining level & turned into a virtuous cycle. The high exchange rate for JPY is now hurting its export & has prompted sharp drop in the share price of many Japanese exporters. Some quarters in Japan have talked about the need for a coordinated effort- with other G7 nations- to check the rise of the JPY. Yesterday, the rumor of a cut in the interest rate had surfaced, which led to a sharp drop in the JPY. Will the slide in the JPY continue? Will it be sufficient to break the cycle of selling brought about by the unwinding of the yen carry trade?

From Chart 1 below, we can see that JPY index has risen 20% from a low of 90.4 on Oct 17th to a high of 109.25 on Oct 26th, before correcting back to 102.3 yesterday. Further weakness could send JPY to its short-term uptrend support of 96. This is also a good horizontal support level. If this support level is violated, then JPY may drop to its medium-term uptrend support of 92. This is also a good horizontal support level (see Chart 2).


Chart 1: JPY's daily chart as at October 28, 2008 (Source: Stockcharts.com)


Chart 2: JPY's weekly chart as at October 28, 2008 (Source: Stockcharts.com)

While we are on the chart of JPY, we might as well check on the direction of the USD. From Chart 3 below, we can see that the USD's immediate support is at its short-term uptrend support of 84-85 level. If this level is violated, USD could slide back to horizontal support of 80-81 and thereafter its medium-term uptrend line support of 78-79.


Chart 3: USD's daily chart as at October 28, 2008 (Source: Stockcharts.com)


Chart 4: USD's weekly chart as at October 28, 2008 (Source: Stockcharts.com)

While both JPY & USD are in overbought territory- which could signal potential corrections ahead- both the short-term & medium-term outlook of these currencies are still bullish. This means that we can expect more selling of equity & other assets class going forward.