As Japan heads for an unprecedented market holiday, investors around the globe are fretting over the risk of a 'flash crash' or violent spasm in currencies that can occur when traders are away and turnover is super thin. Japanese markets will be shut from April 29 to May 6, easily the longest break in modern times, to celebrate Crown Prince Naruhito's enthronement as the next emperor.
Prudent investors are preparing with a variety of strategies, including cutting their holdings in the yen and increasing hedges on their foreign exchange exposures, several money managers and analysts told Reuters. Some are looking deeply into the holdings of Japanese retail investors - known in the market as "Mrs Watanabes" - whose large wagers and herd behaviour can roil prices.
"We see the upcoming Japanese forex liquidity drought as offering danger for corporates, but perhaps opportunity for speculative accounts," said Sean Callow, the Sydney-based currency strategist at Westpac. "Corporates need to beware of the potential for dislocative price action as seen in January, triggering stop-loss orders and causing collateral damage even to non-yen forex pairs. Higher forex hedge ratios may be prudent."
Investors have already suffered two flash crashes this year when Japan was shut. One came in January when the safe-haven yen spiked and sent an array of currencies sensitive to risk appetite tumbling. Another followed in February when the Swiss Franc saw wild gyrations.
"I would be especially cautious around the middle of next week, on May 1," said Marios Hadjikyriacos, a Cyprus-based investment analyst at broker XM. Not only are Japan and China off, but most of Europe will be away for Labour Day.
"Liquidity may be in very short supply until US traders get to their desks ahead of the Fed meeting that day." The US Federal Reserve holds a two-day policy meeting on April 30-May 1, dropping a potentially very large market risk into a very shallow trading pool.
China will also release key economic activity data on April 30 and May 2, while the protracted Sino-US trade negotiations also resume next week. Traders worry that adverse news could force investors out of short positions in the yen, which they customarily borrow to fund purchases of higher yielding but riskier currencies.
This is exactly what happened in January when a torrent of stop-loss sales sent the US dollar down almost four whole yen in a matter of minutes. Some analysts suggest investors should buy the yen against the Australian dollar, taking the opposite side of what is a popular carry-trade for Japanese retail investors.
Another recommendation is to essentially buy insurance against wild moves by being long the 'implied volatility' - market expectations for future volatility - on the Aussie-yen pair. Mrs Watanabes are already working at it by borrowing dollars to buy yen, data from the Tokyo Financial Exchange shows. Their net short dollar/long yen positions hit an all-time high of 223,202 contracts on April 17, worth $2.32 billion.
They have also slashed bets that the yen will fall against the Australian dollar, a favoured play, to a 14-month trough. Yet, they still have heavy exposure to the Turkish lira and the South African rand, with long positions in Turkey's currency above levels seen during the January crash.
"The yen is susceptible to both a big up-move during Golden Week from forced position liquidation were the Lira (or Rand) to weaken significantly, but also an amplified down move were the US dollar to strengthen significantly," Ray Attrill, Sydney-based currency strategist at NAB, said in a note.
In anticipation of possibly sudden market moves, the Tokyo Financial Exchange has asked its retail clients to beef up their margin deposits or lighten their positions before the holidays, manager Yasuhiro Fujitmoto told Reuters. There are also signs that investors globally are betting on a steep yen rise in the short-term, particularly through yen calls in the options market.
Ironically, the general drop in currency volatility in recent months further adds to the risk of a flash crash. Derivative traders have been tempted to sell implied volatility across markets in the expectation that all will remain quiet. If volatility were to spike suddenly, many of those positions could also be under water, forcing more short-covering.
Indeed, one-month implied volatility in the Japanese yen is now around 4.5, lower than during last year's Golden Week of around 7. Kenneth Broux, a currency strategist at Societe Generale in London, said Japan's Golden Week holiday had been a non-event in the last few years for the currency markets. "...but with volatility so low, the risk that we can see an event risk hitting FX markets has grown. There is no shortage of events during that period," he said.
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