The Strength of The Japanese Yen

What is the outlook for the Japanese Yen, given that the Yen has fallen so much this year.

This fall was largely driven by interest differentials, as rising global interest rates – due to high commodity prices and broad-based inflation – combined with the Bank of Japan’s yield curve control (YCC) to move differentials sharply against the Yen, says the International Institute of Finance.

The Bank of Japan added fuel to the fire in this Yen weakness with unprecedented QE purchases of JGBs, thereby underscoring its commitment to YCC.

“As global recession fears mount, driven by sharply tighter financial conditions in the US, COVID lockdowns in China and Russia’s invasion of Ukraine, we think the forces that drove the Yen weakness may now go into reverse,” the institute says.

Markets are bound to price out substantial hiking cycles across advanced countries, which will move rate differentials against the Yen, potentially in a repeat of 2008, when global central bank easing set off substantial Yen strengthening.

Markets are not yet prepared for Yen strength. Speculative positioning in global FX markets remains substantially short Japan’s currency, raising the risk of disorderly adjustment if global recession fears mount further.

The Japanese Yen and inflation

The Japanese Yen has weakened sharply in recent months. Indeed, in real effective terms, which means factoring in inflation differentials, the Yen is down 42 percent over the past decade, compared to the 50 percent drop of the Turkish Lira over the same period (Exhibit 1).

The recent fall in the Yen came amid a severe test of the BoJ YCC framework. The global rise in yields, fanned by inflation and overheating fears, caused markets to speculate that the BoJ would lift its target of zero for the 10-year JGB yield or perhaps even abandon YCC altogether.

The Bank of Japan had to buy unprecedented amounts of JGBs to maintain its YCC commitment, with purchases far exceeding anything seen previously (Exhibit 2).

However, keeping YCC comes at a cost. Much as recent Yen weakness was due to rising global yields, which drove interest differentials against the Yen (Exhibit 3), mounting global recession fears are altering this picture rapidly.

Unlike Japan, money market curves price substantial hiking cycles for central banks in all G10 countries.

Rising odds of global recession mean these hikes will get priced out (Exhibit 4), so that rate differentials will move – perhaps quite sharply – in favor of the Yen.

This will put appreciation pressure on Japan’s currency and signals that the recent period of Yen weakness is most definitely over.

“Markets are not remotely ready for this. We regularly report on speculative positioning in CFTC data that track positioning in global foreign exchange markets,” it says.

Yen and global recession

Speculative positioning remains substantially short the Yen (Exhibit 5), even as global recession fears mount and oil prices – usually seen as a drag on the Yen – fall given the weaker global demand outlook.

wasThe fact that Yen positioning has not even begun to adjust is all the more notable because positioning has started to shift on the Euro (Exhibit 6), where Euro longs against USD was cut recently as markets began to price rising likelihood of Euro zone recession.

The lack of change in yen positioning raises the risk of disorderly adjustment and rapid Yen appreciation.