Track Interest Rate Speculation Through Currency Pair

While a lot of investors think it is the improving economy that is propping up the stock market, the real factor is always about the money printing press. For all those who remembered Q1 of last year, which now seems a lifetime ago, all the bulls were talking about V-shaped recovery, but got creamed when the Greece crisis hit. They were saved only when QE2 came to save the day again. Recently JP Morgan's semiconductor analyst, Christopher Danely, gave investors the clue on the real reason stocks continue to go up:

Our previous cautious stance on the semiconductor group was also driven by our belief that the stimulus-driven economic recovery would eventually collapse. While we continue to believe this is likely at some point in the future due to unsustainable debt, we also view it as unlikely to happen for at least the rest of the calendar year, and it also appears likely that QE2 will be followed by QE3, keeping the economic recovery going for at least another few quarters.

For most industrial sectors, their analysts basically all subscribe to the same belief for going bullish, although most of them will masquerade their analyses with jargons, rather than telling it in plain truth like Danely did.

The great debate for the stock market therefore is not about employment at all, when in fact 9% unemployment is a better investment environment than a 7% employment environment, because we can be certain that more money will be dropped from a helicopter. It is therefore essential to monitor speculation of short term interest rate to determine what traders think the direction is. While we can follow US treasury auction, the real pricing of it is highly distorted by the QE2 program, where the Fed is likely to complete it regardless of any market conditions, just to prove that they can. If people think higher oil or higher food cost will deter the Fed, it seems like they are determined to drive those prices even higher by another QE program. Nonetheless, we can never be certain, and so we must monitor interest rate speculation.

One instrument that could be used for monitoring US short term interest rate speculation is the USD/JPY currency pair. Instead of following another currency pair, such as EUR/USD, the fact that there's a high spread of interest rates between Euro and Dollar makes it difficult to be used since plenty of investors just buy Euro to get the interests. Euro's inherit risk due to its PIGS members also makes it unsuitable in this case. However, it is highly unlikely that Japan will increase interest rates given its monetary policy history, and so the speculation of the currency pair more closely tracks the anticipated strength of short term interest rate between the two currencies. Assuming that Japan will not increase its interest rate, the speculation is then rested more on the direction of US Dollar interest rate.

Currently USD/JPY has bounced off its lower trend line at 81.25, but has not established a clear trend of breaking out. If investors see continued strength in USD/JPY, they should take note and be careful on continued equity appreciation.