What does the yen weakness tell us?

>> Worrying signs for yen

One conclusion we can reach is that the FX market has become what we might call a more ‘technical’ market in the sense that currency trading is increasingly dominated by carry trade considerations and this leaves the yen as the big loser as the BoJ has (up until recently) kept interest rates down when everyone else has lifted them. But what we want to talk about here is not the future of the carry trade but a corollary of this observation, which is that if the only thing that matters to the FX market is the carry trade, then everything else, by definition does not matter, which is why other currencies are so static.

This is important because it is not as if the G10 economic, monetary policy, and political landscape has been boring. Far from it; things have been hugely volatile in recent times. Significant economic divergence has developed between the US and the rest of G10, inflation has risen to levels not seen since the 1980s and then fallen again.

Central banks have raised policy rates much faster than the vast majority of those working in the financial markets can ever remember and, this year there’s been election after election with a number of surprising outcomes and many countries seeing wholesale political change. It has been far from dull. But the G10 FX market has been dull.

In fact, even the yen’s decline has been quite dull in the sense that it has been pretty monotonic, only punctuated by odd bouts of BoJ intervention. Taking all this into account, it could be that the economic/monetary/political environment is just so uncertain that few traders and investors are prepared to bet heavily on big currency movements and, instead, simply prefer to sit on the weak-yen gravy train via the carry trade.

If we assume that this is an accurate characterisation of the FX market at the moment, what does it mean for the future? It would seem to suggest that, as long as the yen-funded carry trade remains an easy gravy train to ride, traders and investors will stay on board and economic/monetary/political surprises will fail to ignite other currencies such as euro/dollar or sterling/dollar.

It might mean that things like the first Fed rate cut, political change in the US Presidential election, and a whole lot more will essentially be ignored, or at least not provoke the sort of directional currency movement that we might ordinarily expect. For some, this might seem a surprising thing to say.

For if the Fed is essentially holding the rest of the world hostage with its tight monetary policy, surely a hostage release rate-cut will generate significant volatility, probably in the form of a much lower dollar. And who believes that a seismic political change in the US from current president Biden to former president Trump in November could generate no more than a yawn – and no volatility – in the FX market? It might seem hard to believe, but if the history of the last couple of years is to be believed, it seems quite logical.

>> Will the yen’s recovery require more FX intervention?

This being said, we raised the question about the FX markets unresponsiveness to important events under the caveat that the yen-funded carry trade remains a source of easy money for traders and investors. But we all know that this particular gravy train is getting closer to the final destination; the BoJ is starting to lift rates and, later this month, will likely start to reduce the amount of JGBs that it is buying.

Now, whether this move on JGBs or the next BoJ rate hike breaks the back of the carry trade is hard to say. We doubt that it will. But eventually the ride will be over, and, once that happens, we may find that FX traders and investors have to start to work for a living and sound out profitable FX trades in other currencies.

In other words, the yen weakness we see now and the lack of volatility in other G10 currencies, like euro/dollar won’t last. But this is the easy answer; the hard part is knowing when it will end. It might take a few Fed rate cuts and a political earthquake in the US election to make it happen but we believe it will happen before the year is out.