The fall of the Japanese yen increases the potential for broader market problems

The Japanese yen has fallen to a 20-year low against the US dollar. That could be bad news for markets far beyond Tokyo.

Traders around the world are watching the rise and fall of the yen not only to follow the Japanese markets, but also to measure how investors globally are doing. Usually, when markets rise, the yen tends to weaken against other currencies. When markets become turbulent, the yen tends to gain ground.

That dynamic has been reversed this spring.

The yen has fallen 12% against the dollar in 2022, even as the war between Russia and Ukraine sent global equities to fall. Its decline has been so steep that it ranks as the worst performing currency this year out of 41 tracked by The Wall Street Journal – worse than the Russian ruble or Turkish lira.

If the yen were a smaller currency, its fall might have less impact on financial markets. But the yen is the key to global finance, and ranks as the third most traded currency in the world. Its rapid decline is going to affect not only Japan, but also something that is seemingly distant from the country: the $ 23 trillion US Treasury market.

The Federal Reserve is ready to begin winding down its comprehensive bond buying program as early as next month. The central bank expects investors such as Japanese institutions – the largest foreign buyers of US government bonds – to step in and help absorb the increased supply of government bonds in the market.

But the yen’s route could cut Japanese demand for government bonds. This is because as the yen weakens, Japanese investors with dollar-denominated assets will have to pay more to hedge against the risk of currency fluctuations cutting their returns.

In theory, relatively generous US interest rates should make the Treasury still attractive to Japanese investors. The 10-year-old U.S. Treasury Department has a return of 2.905%; the 10-year Japanese government bond has a relatively meager yield of 0.25%.

But hedging has become so expensive that the extra return a Japanese investor would get by holding government bonds instead of Japanese government bonds has almost disappeared. After recognizing the cost of taking out currency protection, the difference between the 10-year government yield and the 10-year Japanese government bond yield is only 0.2 percentage points, a Goldman Sachs Group Inc..

analysis using 12-month rolling hedges found.

Due to “fears of the weakening of the weak Japanese yen and expensive US equities”, Japanese institutions such as insurance companies are likely to focus their portfolios more on ultra-long Japanese government bonds rather than US assets, says Daisuke Karakama, chief market officer. economist at Mizuho Bank, in emailed comments.

Japanese investors who decide to stay in the Treasury market can circumvent higher hedging costs by failing to take protection against currency fluctuations, said Ugo Lancioni, head of global currency at Neuberger Berman.

But it involves its own risk. If the yen rises sharply against the dollar, “your yield advantage could be completely eroded in a matter of days,” said Mr. Lancioni. Traders betting on persistent yen weakness were burned by rapid and violent settlements of this bet during the Asian financial crisis of 1998, as well as the great financial crisis of 2008.

Data show that Japanese investors have trimmed their foreign bond holdings. They have been net sellers of foreign bonds in all but one month since November, according to Japan’s Treasury Department, and sold net for 2.36 trillion yen ($ 18.4 billion) in overseas bonds last month.

A more pronounced withdrawal in bond purchases from Japanese investors would come at a particularly inappropriate time for their US counterparts. Bond investors have already taken large losses this year.

There is also a danger that sales of US bonds will surge across other markets – something investors will see in the first few months of 2021. Japanese banks, insurance companies and other institutions dumped tens of billions of dollars of US bond holdings prior to the close of Their fiscal year, exacerbating a sharp rise in bond yields, especially during Asian opening hours. US stocks fell.

Many attributed the fall in equities to the rapid rise in bond yields. Higher interest rates reduce the premium investors get by holding more risky assets over Treasurys, making the stocks look less attractive.

Why is the Japanese yen falling so much?

Traders say an increasingly divergent central bank policy has driven the fall of the currency this year. The Fed raised interest rates in March for the first time since 2018 and signaled that it could raise interest rates six times more by the end of the year as part of an attempt to combat a sharp rise in inflation. But the Bank of Japan has remained firmly committed to keeping interest rates close to zero. The growing gap between the prices in Japan and other countries has pushed investors to dump Japanese assets in the yen and pick up assets in dollars, which stand to provide higher returns. It has sent the yen to levels that few expected at the beginning of the year.

In the end, the shares came quickly after the 2021 episode, noting double-digit percentage increases for the year. But some investors see the possibility of another withdrawal.

“If we get another round of bond sales, it’s likely to challenge the stocks further,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group.

There is a chance that the fall of the yen will reverse before investors see wider market waves. Speculators who have loaded up on bets on the fall of the yen may abruptly settle their positions, causing the yen to strengthen rapidly, not only against the dollar, but other currencies against which the yen is trading strongly, such as the Brazilian real and the Australian dollar .

But so far, there are few indications that such a move is happening.

Hedge funds are still betting strongly on the yen falling further, with net positions against the yen recently hitting their highest in more than three years, according to the latest data from the Commodity Futures Trading Commission.

“I do not see any force that will stop it at this point unless Japan changes its tactics,” said Mark Grant, chief strategist at Colliers Securities.

The second potential trigger for a turnaround in the yen: more harsh intervention from Japan. The Bank of Japan could consider raising interest rates earlier than expected, or the Ministry of Finance could intervene directly in the foreign exchange markets.

Still, some investors are skeptical that Japanese officials will step in.

Inflation has not been warm enough in Japan for the Bank of Japan to necessarily justify raising interest rates, said Idanna Appio, portfolio manager at First Eagle Investment Management.

“Maybe if the yen worsens significantly from here, or there was political pressure from other countries like the US that said Japan was trying to gain an advantage, they would step in. But I do not see that happening,” Ms Appio said.

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So far, some investors are waiting on the sidelines instead of trying to time bets on the yen’s movements.

“It’s reaching an absurdly cheap level,” Peter Kinsella, global head of currency strategy at Swiss private bank UBP, said of the currency.

Mr. Kinsella had bet that the yen fell against the dollar until a few weeks ago, when he settled the deal because he thought it had run too far. If the yen exceeds 132 or so relative to the dollar, he said he would consider betting on it rising.

Write to Akane Otani at akane.otani@wsj.com and Caitlin Ostroff at caitlin.ostroff@wsj.com

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