USD/JPY a Tightly Coiled Spring

The USD/JPY exchange rate is at a pivotal turnrning point. After spending the last seven months trading up and down in a sideways triangle patternrn, this pair is wound tight like a spring.

Get ready for an explosive move!

The converging red lines I’ve drawn on the chart below show the triangle, or coil, patternrn. This is a typical congestion patternrn. It typically develops after a strong trend move, providing a pause as investors reevaluate their positions and outlooks.

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I think this pair will break out of the triangle to the upside – hence, a strengthening U.S. dollar and a weakening yen.

However, there’s a case to be made for the opposite move. I just want to keep this in mind for risk management purposes. So, here’s the bearish case for this patternrn:

From 2007 to 2013, the yen got stronger against the dollar (the down trend you see above). I’ve drawn Fibonacci retracement lines around this move, showing a likely pullback in the 2007 and 2013 downtrend should end between ¥100 and ¥105. And that’s basically what happened when the 2013 rally was halted just below ¥105.

So, if you’re still bearish the dollar and bullish the yen, you’d expect the pair to break down from the triangle patternrn and eventually fall well below ¥75.

But I think there’s very little chance of that happening.

Prime Minister Shinzo Abe is hell-bent on devaluing the yen. And now that Toyota has overtaken GM as the global leader in sales, Japan’s corporations are benefitting greatly from the cheaper yen, as their wares are now more affordable on the global market.

I think Abe will up the ante and devalue the yen even further. Meanwhile, the U.S. economy is still proving itself as the strongest in the world. That supports the bullish case for the U.S. dollar.

So, I’m anticipating the rally in USD/JPY to continue higher, once the triangle patternrn is broken. And here’s how you might construct a trade…

A break above ¥101 will convince me that the triangle patternrn of indecision has been broken. Consider adding bullish dollar and/or bearish yen positions on a break above ¥101 (blue dotted line).

For risk management, consider exiting long USD/JPY (or similar) positions if the pair breaks below ¥95 at any point (pink dotted line). That sets the risk on this trade at six yen.

The upside potential on a bullish rally is about 3.5 times more than the risk, with my profit target sitting at ¥120.

If you’re not inclined to make this trade in the forex market, there are other ways to play this trend. To find out more, keep reading Boom & Bust or consider signing up.