Chart of the Week

A TUMBLING YEN

Something big seems to be brewing in currency markets with the Japanese Yen witnessing a 10%+ sell-off against the US dollar so far this year. It recently hit a three decade low around ¥160; a huge move for one of the world’s largest FX pairs.

So why is the Yen trading like an emerging market currency?

The recent increase in US bond yields has strengthened the US dollar, which has a direct (negative) impact on the Yen. If the US and Japanese economies were perfectly in sync, JGB yields would rise to a similar extent and that would largely neutralise the consequences for the currencies.

But that isn’t the case because the Bank of Japan (BoJ) is still pursuing a much looser monetary policy than the Federal Reserve, given the country’s colossal government debt/GDP ratio of over 250%, which easily eclipses America’s own fiscal problems.

Simply put, there is very little scope for Japanese bond yields to increase before they trigger a major debt refinancing crisis, which is why the 10yr JGB yield has risen only 0.3% this year (to 0.9%). Over the same period, the 10yr US Treasury yield has gone from 3.8% to 4.6%.

However, the defence of the Japanese bond market is coming at a cost via the weaker currency, which has accelerated in recent weeks.

In turn, this increases the likelihood of Japanese policymakers stepping in to support the Yen. Historically, they have done so by selling their dollar reserves and buying Yen with the proceeds. But that means selling some of their gargantuan US Treasury bond reserves, which totalled U$1.2trn at last count. And doing so forces US yields higher, catalysing the strong dollar/weak Yen dynamic again.

This is a complex and messy relationship known as an “FX doom loop”. One solution would be for the Federal Reserve to cut rates, but that seems unlikely with US growth and inflation perking up. This leaves other dollar liquidity provisions as a potential Yen saviour, including the reintroduction of FX swap lines or some form of Fed balance sheet manipulation.

We wouldn’t be surprised to see a co-ordinated Central Bank intervention over the coming weeks, aimed at keeping the dollar rally in check. In fact, based on the recent Yen bounce some “stealth” intervention may already be underway.