The Japanese yen (JPY) is the third-most traded currency in the foreign exchange (forex) market after the US dollar and the euro, as well as an important reserve currency. Yen traders have had a wild ride recently with USDJPY rising from 110 to 150 during the inflation scare of 2022, which prompted a few rounds of currency intervention by the Japanese authorities in late 2022 and a hawkish tilt from the Bank of Japan (BOJ) at the December meeting. Since then, traders have been waiting for more hawkish signals from the central bank but continue to be disappointed. In the article, we will look at some of the factors that drive the biggest moves in yen.
Carry trades amid yield differentials
Japan has maintained very low interest rates for many years, and that has made JPY as the funding currency of the world. That means people can borrow yen cheaply to buy higher-yielding dollars or other currencies and seek higher interest rates in instruments such as Treasury bonds to boost their returns. This has led to a close relationship between the Japanese yen and US Treasuries. When yields on Treasury bonds rise, yen tends to weaken relative to the dollar. As long as the differential between Treasury yields and Japanese yields (which are fixed) continues to widen, there will be downward pressure on the yen.
BOJ policy expectations
Changes in central bank policy always plays on the minds of currency traders. More importantly, expectations of changes in central bank policy are key and usually influenced by economic growth, inflation, wage growth and other high frequency data. If data supports a stronger economy, market participants expect monetary policy could be tightened and that results is stronger currency.
The BOJ is the only major central bank to engage in outright yield-curve control, buying 10-year Japanese bonds to cap yields at 0.5%. Recent inflation trends in Japan have turned a corner, with inflation rising to over 3% YoY levels after years of deflation. This return of inflation suggests scope for some of the stimulus from the Japanese economy to be removed to avoid overheating, and that leads to expectations of a stronger yen. However, Japanese authorities continue to view the current inflationary pressures as temporary and import-driven, and have been resisting the pressure to normalize monetary policy.
With the yen at a historically low level against the dollar, the Japanese people have been left with a difficult choice to either continue to hold their savings and investments in the yen, or move money into foreign currencies. Banks have noted a surge in the latter and this could also prompt a re-think of the easy monetary policy. If that happens, the yen will likely strengthen, but be prone to significant volatility.
Any signs of BOJ tightening could lead to massive liquidity drain on the global economy as the carry trades that use the Japanese yen as the funding currency could start to be reversed. This explains market’s nervousness.
Interventions mean the government and central bank actively buying or selling in the open market to push the currency in the desired direction. Such interventions are unorthodox for developed economies, and last year Japan engaged in currency intervention for the first time in 24 years. Usually, results of interventions are also short-lived.
Historically, Japanese authorities have had a preference for a weak yen as it boosts exports and the industrialization of the Japanese economy. Therefore, interventions have mostly been seen when the yen became too strong. However, the most recent episodes of yen intervention in 2022 were intended to strengthen the yen after steep weakening. A lot of Japanese companies have also now shifted their production overseas and that means that a weaker yen isn’t benefiting export companies as much as it once did. Japan is also reliant on importing a lot of resources, mainly energy, and a very weak yen makes that expensive. Moreover, authorities usually intervene not because of a particular level that the currency has reached, but more if the pace of movement in the currency has been steep.
The Japanese yen is currently holding near a 7-month low against the US dollar and close to levels where intervention was seen last year. If the yen weakens again in response to a rapid rise in Treasury yields, currency intervention concerns could grow and that limits the scope for further yen selling. Recent US move to remove Japan from currency intervention watch list has also opened up further scope for the Japanese authorities to intervene without being labelled as a manipulator. Still, ammunition is likely to be preserved until USDJPY reaches closer to 145.
The Japanese yen is also considered a safe haven in times of economic or geopolitical stress. This means that the yen rallies when equity markets come under pressure, and it is therefore used for de-risking portfolios when economic conditions are expected to worsen. What made yen being tagged as a safe haven was the fact that Japan invests in high-risk bonds outside the country, and when conditions deteriorate, they can sell those bonds and convert to yen which creates a massive demand for yen and makes it strengthen. The yen is also very liquid so can be traded easily and is generally backed by a stable government.
Trading the yen
That means a yen trader has several macro drivers to keep in mind to assess the path of the currency. As such, short-term traders need to watch the 2-year Treasury yields and the direction of the stock market, while the long-term investor will need to focus on long-end yields such as that of 10-year or 30-year Treasuries. The view on JPY would therefore be a function of the macro view, and we could consider the following scenarios:
- If you’re in the recession camp, expecting a slowdown in the pace of economic activity in the coming months, that means you would expect the Fed funds rate to be revised lower. This could mean lower Treasury yields as rate cuts are priced in by the markets, and this allows the Japanese yen to strengthen. Even if recession concerns lead to the USD’s safe-haven bid coming into focus, pressure on yen could remain minimal and yen could strengthen against other currencies. Currently however, economic data continues to be resilient and therefore, a deep recession appears unlikely.
- On the other hand, if you continue to expect higher economic growth and high inflation, then we can see the Fed rate hikes making a comeback after a recent pause and interest rates staying higher-for-longer. This means Treasury yields could keep moving higher, pressuring the yen. This could forcing Japanese authorities to intervene (which can have a temporary effect) or normalize monetary policy. However, BOJ appears unlikely to yield to market pressure and has now added wage growth as another key metric for them to consider policy normalization.
- The third scenarios is the toughest to play. If the Goldilocks continues – growth metrics hold up while inflation continues to soften – that will keep the yen in the hands of the speculators. But an overall weakening bias for the yen may remain amid the policy divergence of the US and Japan. US equities may continue to rally in this case, which means investors will continue to convert yen to dollar to enjoy a combination of equity gains and carry returns.
US data remains a key focus to assess the probability of these scenarios. The incoming US earnings season (starting late July) could also bring a test of the US consumer and growth, and any downside surprises in the earnings results or outlook could mean the recession scenario could start to get priced in by equities that have been recently boosted substantially by the AI craze.
The next two BOJ meetings (28 July and 22 Sept) are live and will drive a lot of interest from traders and underpin significant volatility in the yen. If inflation continues to prove more persistent compared to the central bank’s expectation of core inflation coming down in H2, then traders may use options to position for a hawkish BOJ surprise.