Japan & Switzerland Spring Surprises with Policy Shifts

Japan Nikkei 225 Index and CHF/JPY

This strategy requires an experienced investor to go long on Japan Nikkei 225 Index and simultaneously go short on CHF/JPY.

Historical 5-Year Performance of Long:
Nikkei Index & Short: CHF/JPY

*past performance does not guarantee any future results

Long: Japan Nikkei 225 Index

Nikkei Index represents the performance of the Tokyo Stock Exchange (TSE) and is calculated based on the share prices of 225 of the largest and most actively traded companies listed on the TSE. The Nikkei Index is a price-weighted index, rather than market capitalization. It includes companies from various sectors, such as technology, automotive, finance, and manufacturing, providing a broad representation of the Japanese business landscape

Bank of Japan's Historic Policy Shift

The Bank of Japan has made a significant shift in its monetary policy with Japan's central bank increasing interest rates from below zero to a range of 0-0.1%, marking the first time in 17 years that rates have been raised. This move brought an end to the world's last negative interest rate regime among major economies. The decision to abandon negative rates was prompted by signs of strong demand and the anticipation of higher wages leading to increased prices for goods and services.

Rengo, Japan’s largest labor union umbrella group, announced that its members secured an average 5.3% increase in pay during the annual spring wage negotiations, the most significant gain since 1991. Major companies in Japan have also offered substantial pay hikes during this year's wage talks, raising hopes for sustained inflation around the Bank of Japan's target.

In February, Japan's consumer price index (CPI) rose by 2.8% on an annual basis, accelerating from a 2.2% increase in January. This marked the 23rd consecutive month that the figure has met or exceeded the central bank’s 2% price target.

The inflationary mindset has begun to take hold among households and corporations, evidenced by rising expectations for positive wage growth. This sets in motion a virtuous cycle of increasing wages and prices, which in turn is expected to stimulate domestic consumption. Despite not having fully recovered to pre-COVID levels, domestic consumption remains a potential upside for reflation. This is beneficial for corporate profits and long-term investment and growth.

This suggests a potential positive outlook for the Nikkei 225 index, as it indicates a potential end to Japan's 30-year economic slump and bolstering investor confidence in the market's stability and growth prospects.

Government Incentives

The introduction of the Nippon Individual Savings Account (NISA) in 2024 is set to make domestic individual investors net buyers, offering a small investment program amid declining real yields on bank deposits. This could shift approximately $14 trillion in household financial assets towards higher-returning risk assets, fostering an equity culture in Japan. Increased demand for risk assets, in turn, would likely be a very positive development for Japanese equities over the medium and long term.

Technical Analysis

CHF/JPY – Daily Chart

*Last price as of 1st April 2024
Source: Trading View

From a technical perspective, the Nikkei Index has given a breakout from its long-term upward trending channel (blue channel), trending from 2013, suggesting a very strong bullish bias. Furthermore, the index also witnessed a breakout after the formation of a bull flag (red channel), strengthening the bullish forces. Looking ahead, given the fundamentals, the bullish trend is expected to continue, with the index also receiving support from the 50-Period-SMA (yellow).

Short: CHF/JPY

CHF is on the brink of weakness amid a surprise by the Swiss-National-Bank

Fundamental Analysis

The recent sharp downturn in CHF/JPY is primarily attributed to actions taken by the Swiss National Bank (SNB), which surprised markets with a 25-bps rate cut to 1.5% on its key policy rate, marking the first cut in nine years. This decision was driven by concerns over the Swiss franc's persistent strength and inflation levels. Inflation in Switzerland stands at a modest 1.2% year-on-year, and the nation has a longstanding struggle with deflation and disinflationary pressures associated with an overvalued exchange rate.

Switzerland CPI Y-o-Y

*Last price as of 1st April 2024
Source: Bloomberg

Looking ahead, the Swiss franc is expected to remain under pressure due to lower inflation projections and efforts to prevent any appreciation in the currency. Market sentiment believes that this level is still too strong for policymakers’ liking, with analysts expecting franc weakness to persist.

The Swiss franc remains one of the most overvalued currencies in real terms. With inflation decreasing rapidly and lower inflation projections, there is room for this trend to continue. The CHF has already been an underperformer this year and is now likely to extend this underperformance. Being the first G-10 central bank to cut rates, the Swiss franc is gaining traction as the market's preferred currency for funding carry trades. With the CHF increasingly seen as a funding currency of choice, it is perceived to likely remain undervalued.

On the other hand, caution surrounds shorting the yen as the Bank of Japan recently ended its negative rate policy and raised rates for the first time in over a decade. Additionally, policymakers' threats of intervention to support the yen and its already deeply undervalued status suggest limited potential for further depreciation

Technical Analysis

From a technical perspective, the CHF dipped, retreating from its resistance at 172 on the weekly chart, indicating a bearish bias. The reversal in the bullish trend of CHF/JPY occurred in late January; however, the recent sudden rate cut by the SNB, as mentioned above, influenced this shift. Regarding target levels, the price range of 149.46 to 150.4 appears as an attractive target level, supported by the presence of strong bullish order blocks. In the medium term, the 160-price mark serves as a robust support level. Nonetheless, the currency pair continues to find support from the 50-period SMA(yellow). In terms of the RSI, the indicator is currently at 60 at the time of writing and has already declined from the overbought level, further corroborating the bearish bias

Policy Divergence

Japan Interest Rate Probability

The chart below shows that markets are fully pricing in atleast one more rate hike by Bank of Japan by the end of 2024 with an implied policy rate of 0.2% by the end of the year.

*Last price as of 1st April 2024
Source: Bloomberg

Switzerland Interest Rate Probability

The chart below shows that markets are pricing in further rate cuts by Swiss National Bank by the end of 2024 with a fully priced-in rate cut in the September 2024 meeting.

*Last price as of 1st April 2024
Source: Bloomberg

Scenario Analysis of CHF/JPY and Nikkei

*Last price as of 3rd April 2024
Source: Bloomberg
Note : Holding Cost and Dividend are not included in the returns calculation

Strategy Rationale:

The fundamental idea behind the strategy is that Japan 225 could like continue to outperform in the long run despite a potentially likely scenario of the Yen appreciating. Hence going short on the CHF/JPY pair could be a strategic hedge against Nikkei in case of downward trending markets.

By doing so, the investor will likely incur a holding cost of 2.57% per annum, currently applicable to the Japan 225 index, and will likely face a holding cost of 4.65% applicable to the CHF/JPY currency pair. On a net basis, investors will be paying holding costs of around 7.22% per annum (with 2x leverage)

However, it is essential to note that Pair Trading is not a risk-free strategy. The difficulty comes when prices of the two securities move contrary to the positions taken, resulting in losses. Thus, adhering to strict risk management rules is vital when dealing with adverse situations.

Past performance is not indicative of and does not guarantee future results. Trading in markets may involve loss of capital.

Note: The return calculation includes the holding cost paid on the strategy and this could change in the future, impacting the strategy either positively or negatively. The returns do not consider the currency depreciation of the Yen, US Dollar and the Swiss Franc. Investors will have to hedge the currency exposure separately.

Source: Bloomberg
Data and Prices as of 3rd April 2024