The Japanese yen has fallen to a 20-year low against the US dollar. That risks being bad news far beyond Tokyo, in the $23 trillion market for US Treasuries.
Traders around the world watch the rise and fall of the yen not only to follow the Japanese markets, but also to gauge how investors are feeling globally. Generally, when the markets are rising, the yen tends to weaken against other currencies. When markets turn turbulent, the yen tends to gain ground.
That dynamic has changed this spring.
The yen is down 12% against the dollar in 2022, even as the war between Russia and Ukraine sent global stocks tumbling. 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 the Turkish lira.
If the yen were a smaller currency, its decline might matter less to financial markets. But the yen is key to global finance, ranking as the world’s third most traded currency.
The Federal Reserve is set to start winding down its extensive bond-buying program next month. The central bank is counting on investors like Japanese institutions, the largest foreign buyers of US Treasuries, to step in and help absorb the increased supply of Treasuries in the market.
But the yen’s decline could dampen Japanese demand for Treasuries. This is because, as the yen weakens, Japanese investors with dollar-denominated assets will have to pay more to protect themselves against the risk that currency fluctuations will reduce their returns.
In theory, relatively generous US yields should keep Treasuries attractive to Japanese investors. The 10-year US Treasury has a yield of 2.905%; the 10-year Japanese government bond has a comparatively paltry 0.25% yield.
But hedging has become so expensive that the extra return a Japanese investor would get from holding Treasuries instead of Japanese government bonds has all but disappeared. After taking into account the cost of obtaining currency protection, the difference between the 10-year Treasury yield and the 10-year Japanese government bond yield is just 0.2 percentage point, according to Goldman Sachs Group. inc..
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Due to “fears that the weakness of the Japanese yen and the price of US stocks will reverse”, Japanese institutions, such as insurance companies, are likely to focus their portfolios more on ultra-long-term Japanese government bonds than on assets. Americans, said Daisuke Karakama, head of the market. Mizuho Bank economist, in emailed comments.
Japanese investors who decide to stay in the Treasury bond market could avoid higher hedging costs by giving up protection against currency fluctuations, said Ugo Lancioni, head of global currency at Neuberger Berman.
But that carries its own risk. If the yen were to recover sharply against the dollar, “its yield advantage could be completely eroded within a few days,” Lancioni said. Traders who were betting on sustained yen weakness were hit by the swift and violent reversals of that bet during the 1998 Asian financial crisis, as well as the great financial crisis of 2008.
The data shows that Japanese investors have been trimming their foreign bond holdings. They have been net sellers of foreign bonds in all but one month since November, according to Japan’s finance ministry, selling a net 2.36 trillion yen ($18.4 billion) of foreign bonds last month.
A further pullback in bond buying by Japanese investors would come at a particularly inopportune time for their US counterparts. Bond investors have already suffered heavy losses this year.
There is also a danger that the sale of US bonds could spread to other markets, something that investors saw happening in the first months of 2021. Japanese banks, insurers and other institutions dumped tens of billions of dollars in US bonds before the end of their fiscal period. year, exacerbating a sharp rise in bond yields, especially during Asian trading hours. US stocks plummeted.
Many attributed the stock slump to rapidly rising bond yields. Higher rates reduce the premium investors get by holding riskier assets over Treasuries, making stocks look less attractive.
Why is the Japanese yen falling so much?
Traders say the central bank’s increasingly divergent policy has fueled the currency’s decline this year. The Fed raised interest rates in March for the first time since 2018 and signaled it could raise rates six more times by the end of the year as part of an effort to combat a sharp rise in inflation. But the Bank of Japan has remained firmly committed to keeping interest rates close to zero. The widening gap between rates in Japan and other countries has pushed investors to dump Japanese yen-denominated assets and pick up dollar-denominated assets, which offer higher yields. That has sent the yen to levels few anticipated earlier in the year.
Ultimately, stocks quickly rebounded from the 2021 episode, posting double-digit percentage gains for the year. But some investors see the potential buildup of another pullback.
“If we get another round of bond sales, that’s likely to be more of a challenge for stocks,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group.
There is a chance that the yen’s decline could reverse before investors see broader ripples in the market. Speculators who have been piling up bets on the yen’s decline could abruptly unwind their positions, causing the yen to strengthen rapidly, not only against the dollar, but also against other currencies the yen is heavily traded against, such as the Brazilian real and the Australian dollar.
But so far, there is little sign that such a move is happening.
Hedge funds are still betting heavily on the yen falling further, with net positions against the yen recently reaching their highest level in more than three years, according to recent data from the Commodity Futures Trading Commission.
“I don’t see any force that is going to stop it at this point unless Japan changes its tactics,” said Mark Grant, chief global strategist at Colliers Securities.
The other potential trigger for a yen reversal: more heavy-handed intervention from Japan. The Bank of Japan could consider raising interest rates sooner than projected, or the Finance Ministry could intervene directly in currency markets.
However, some investors are skeptical that Japanese officials will step in.
Inflation hasn’t spiked enough in Japan for the Bank of Japan to necessarily justify raising interest rates, said Idanna Appio, portfolio manager at First Eagle Investment Management.
“Perhaps if the yen were to significantly worsen from here or if there was political pressure from other countries like the US saying that Japan was trying to gain an advantage, they would intervene. But I don’t see that happening,” Appio said. saying.
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For now, some investors are waiting on the sidelines, rather than trying to time bets on the yen’s moves.
“It’s getting to an absurdly cheap level,” Peter Kinsella, global head of currency strategy at Swiss private bank UBP, said of the currency.
Kinsella had been betting the yen would fall against the dollar until a few weeks ago, when he called off the trade because he thought he had gone too far. If the yen breaks above 132 against the dollar, she said he would consider betting on it going higher.
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