Yen at bearish sentiment extreme?

The pendulum of market sentiment swings ever back and forth between fear and greed.

Taking the U.S. dollar as an example, greed was ascendant at the turn of the year. Investors were optimistic about the pro-business policies of President Donald Trump and that the Federal Reserve would be the only major central bank raising interest rates. As the realities of governing and economic hiccups deflated dollar bulls’ wildest hopes, market sentiment swung back to excessive pessimism toward the U.S. dollar. By the end of the third quarter, the fear had reached a short-term extreme, setting the stage for the dollar’s recovery over the last two months.

While these sentiment extremes are difficult to pinpoint in real time, there are some tools that investors can use to help increase their odds. One of the most useful tools is the Commodity Futures Trading Commission’s (CFTC) Commitments of Traders (COT) report, which provides a snapshot of how futures traders are positioning themselves in different assets. When these traders grow lopsidedly long or short in a certain market, it suggests that a potential reversal may be at hand. In other words, when everyone’s already long a market, there’s no one left to buy and vice-versa.

Skimming the latest COT report, there’s a risk that such a situation is developing in the Japanese yen. According to the most recent data (through Oct. 24), speculators are short nearly 177,000 yen contracts, the highest gross short reading on the yen since July 2007 (see “Bearish yen” above). The net short positioning (which accounts for speculators who are long) is slightly less extreme at around 117,000 contracts, but is still within striking distance of the 10-year extreme at about 144,000 contracts. Put another way, net short positioning in the yen is currently in the 97th percentile of all the readings over the last 10 years.

Interestingly, this extreme bearish sentiment in the Japanese currency has developed despite a lack of a clear trend in USD/JPY; the pair has spent almost the entire year range bound in the 108.00-115.00 zone (see “Yen on the range,” below). More broadly, the yen has been a middle-of-the-road performer among the major currencies so far this year, ticking higher against laggards like the New Zealand dollar and Swiss franc, while falling against standouts like the euro and pound sterling.

Fundamentally speaking, it’s clear why traders have staked out such an extreme position. The Bank of Japan (BOJ) continues to aggressively buy assets of all types in an effort to stimulate the economy, and Goushi Kataoka, the newest BOJ governor, has been calling for even more aggressive stimulus in recent months. Despite these unprecedented measures, inflation remains mired well below the central bank’s 2% target, meaning that the easy-money policy is likely to remain in place until 2019 at the earliest.

That said, the night is often darkest just before the dawn. With yen bulls as downbeat as they’ve been in a decade, despite a relatively stable currency, the bar is low for positive economic surprises in Japan. Even if Japan’s economy doesn’t show signs of perking up in the coming months, yen bears could struggle to push the currency lower given the already-lopsided positioning, especially against currencies that speculators have accumulated heavy long positions in, like the euro and Canadian dollar.

Make no mistake; the yen could certainly fall further from here, much as it did after reaching its last sentiment extreme in late 2013. Sentiment and positioning analysis is far from a foolproof tool. But if the recent past is any guide to the future, the forex market’s sentiment pendulum may be reaching its a pessimistic extreme on the Japanese yen.