Worrying signs for yen

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

When it comes to explaining the yen’s weakness in recent years, it is easy to blame the widening interest rate gap. Other central banks have hiked rates significantly, but the BoJ has barely budged. For instance, the 10-year yield gap between treasuries and JGBs has increased from around 50-bps at the time of COVID-19 to some 330-bps today.

Many Japanese investors hedge foreign bond purchases, but the rise in the cost of borrowing US dollars (and other currencies) to buy foreign bonds seems to have pushed more investors to buy bonds on an unhedged basis. That’s clearly important for the US dollar/yen rate as overseas bond purchases using FX swaps do not have a spot component, and hence don’t lift US dollar/yen, while unhedged purchases of treasuries through the FX spot market clearly do involve a purchase of dollars and, all else equal, a higher dollar as a result. And while large Japanese investors might have chosen to switch from hedged foreign bond purchases to unhedged buys, the significant short-term retail FX market (often colloquially termed the ’Mrs Watanabe’ trader) is always likely to be pre-disposed towards the spot market.

But if it is so easy to attribute yen weakness to the widening of rate spreads, it is somewhat disconcerting that these spreads have narrowed quite a bit in the past few months and yet US dollar/yen have continued to rise. Why might this be happening? One explanation is that the market is simply too slow to latch on and, if the spread continues to narrow, we’re likely to see the yen catch up eventually.

While spreads may have reduced, hedge costs are still punitive because the Fed has not started to cut yet, while the rise in BoJ policy rates has been minimal so far. This explanation would seem to suggest that US dollar/yen won’t fall until the Fed eases; something that still seems to be some months away.

Another justification could be that the growing likelihood of a second term for Donald Trump in the US, and the associated risk of new tariffs, will heap pressure on the Fed to keep rates high as inflation could rise, while the BoJ may feel compelled to keep rates down as growth could be hit by US tariffs.

We could list other factors that might explain the yen’s sudden loss of sensitivity to yield spreads at the very time that they are moving in the yen’s favour. But Steve Barrow, Head of Standard Bank G10 Strategy, concerns that perhaps none of these are to blame. That instead, what is happening is that dollar/yen (and the other yen crosses) have entered a speculative bubble whereby all fundamentals, including yield spreads, are unable to reverse the dollar’s uptrend. In Steve Barrow’s opinion, there are some reasons for this.

>> Could conditions be better for the carry trade?

First up, we’d cite the fact that it is only the yen that has slumped. Even other currencies where policy rates are still quite low – and have started to fall again – like the Swiss franc, have fared much better. In other words, the market seems to have it in for the yen for some reason.

A second factor is that short-yen positioning seems very extreme if we look at positioning data such as that in the weekly CFTC report. Thirdly, sizeable intervention from the BoJ is having an increasingly negligible effect. Fourthly, movement in other major currencies like euro/dollar and sterling/dollar has been so minimal in the last eighteen months that more and more FX traders and investors appear to have jumped on the only trend in town; that of the weak yen.

But what can be done if this is correct and the US dollar/yen is in the midst of a speculative bubble? It might be that nothing needs to be done by the authorities, as bubbles usually blow themselves out. While this is possible, a better solution would seem to be for the Japanese authorities to convince other major G7 central banks to intervene as well, particularly the Fed, but this seems a forlorn hope right now.