When the Bank of Japan (BoJ) announced on July 28 that it was easing its 0.50% yield cap on 10Y Japanese Government Bonds (JGBs) to a target level, the currency market wasn’t sure what to make of it. The yen (JPY) first fell by 1.4% versus the U.S. dollar (USD), then rallied by 2.5% before giving up most of those gains.

While the currency market was uncertain as to what to make of the BoJ adjusting its yield curve control policy, the global bond market reacted decisively. 10Y JGB yields rose by 11.6 basis points (bps) to 0.555%, the highest since 2014. Moreover, the bond sell-off wasn’t limited to Japan. Long-term bond yields rose by 1bps to 14bps all around the world.

JPY has been no stranger to volatility in recent years. Between January 2021 and October 2022, JPY lost one third of its value versus the USD. JPY recovered about one third of its losses between October 2022 and January 2023 before selling off again. Several factors have weighed on the JPY over the past two and half years and how these variables evolve going forward may determine JPYUSD’s future course. They include:

  1. Interest rate differentials
  2. Quantitative easing
  3. Economic growth rates
  4. The relative size of trade balances

Interest Rate Differentials

From 2008 to 2021, the difference between U.S. and Japanese rates was small, sometimes even close to zero. However, since the Federal Reserve (Fed) began raising rates in March 2022, the gap has expanded to its widest point since before the global financial crisis (Figure 1). Thus far this century, JPYUSD has often followed the U.S.-Japan interest rate differential (Figure 2).

Figure 1: U.S. Japan rate differentials are at their widest point since before 2008

Figure 2: The differences between USD and JPY yields as a major driver of JPYUSD

Pre-2008, JPY was often used as a funding currency. This is to say that because Japanese interest rates were much lower than rates in other countries, investors would borrow money in yen and deploy that capital in other currencies with higher rates. But such so-called carry trades, while sometimes profitable in the short-to-medium term, expose investors to enormous financial risks as the world discovered in October 1998 during the winddown of hedge fund Long-Term Capital Management. That month, JPY rallied by nearly 20% versus USD in 72 hours as carry trades were unwound as the Fed completed a 75bps policy easing while the BoJ kept its policy unchanged. To the extent that JPY is once again being used as a funding currency today, JPYUSD may once again contain an options-like risk.

The U.S.-Japan interest rate differential has been driven in part by large gaps in inflation. Japan’s inflation, excluding the volatile food and energy sectors, has been below that of the rest of the world for decades as the country oscillated in and out of deflation while Japan’s peers typically had core inflation in the 1-3% range.

The post-pandemic inflation surge didn’t spare Japan, but it hit much later and was seen from a different perspective (Figure 3). When inflation soared far above target in the U.S., Canada, Europe and Australia in 2021 and 2022, central banks reacted first with disbelief, and then with alarm. In Japan, the rise in inflation began about one year later and was greeted, at least initially, with relief: finally, Japan was exiting years of deflation and inflation was coming up to target. Rather than raising rates in tandem with other central banks, the BoJ appeared more concerned about returning to deflation than allowing inflation to increase further (Figure 4). Even so, core inflation in Japan has now far surpassed the BoJ’s 2.5% target and might prompt further tightening action by the central bank.

Figure 3: Japan’s wave of inflation started later and hasn’t gone as high as other nations

Figure 4: The BoJ is one of the few central banks that hasn’t tightened policy

QE and Yield Curve Control

If the BoJ steps up actions against rising inflation, it might further loosen its yield curve controls. Up until late last year, Japan capped 10Y JGB yields at 0.25%. Since then, the de facto cap was first lifted to 50bps, then turned into a target rather than a hard limit (Figure 5). 

Figure 5: Easing the yield caps could cause the BoJ balance sheet losses

To prevent yields from rising beyond the 0.25% and 0.50% band, the BoJ was willing to create however much liquidity necessary to serve as the buyer of last resort for government bonds with maturities of less than 10Ys. This policy inflated the BoJ’s balance sheet relative to the size of the Japanese economy and was much larger than the quantitative easing (QE) programs in the U.S. or Europe (Figure 6). As the BoJ’s balance sheet expanded relative to that of the Fed, JPYUSD tended to weaken (Figure 7).

Figure 6: The BoJ QE was much larger than the Fed’s or ECB’s

Figure 7: More QE often translates into a weaker currency

Once 10Y JGB yields are uncapped, there is a possibility that the BoJ could start to raise short-term rates afterwards. With respect to the twin prospects of ending yield curve control and raising rates from -0.1% to positive levels, there appears to be a naïve assumption that doing so would slow Japanese growth. Underlying this assumption is a belief that yield caps and negative rates support growth. However, the evidence suggests otherwise. Yield caps may actually slow growth rather than support it by discouraging bank lending. Banks lend more profitably when yield curves are steep than flat as banks earn the spread between what they pay for short-term deposits at the bank and the banks’ longer term loans to customers. Secondly, negative rates serve as a tax on the banking system and may cause hoarding of cash rather than expanding lending activity. 

The Growth Differential

The idea that yield curve control and negative rates are burdening Japan’s economy is supported to some extent by Japan’s GDP data. While the U.S. economy has been slowly expanding and Europe’s has been stagnating, Japan’s economy has been shrinking (Figure 8). The shrinkage is driven in part by demographics: it’s population growth is negative, whereas population growth in the U.S. remains positive. This has probably weighed on the yen as currency investors tend to prefer to be “long” in currencies with expanding economies. 

Figure 8: The U.S. has been growing, Europe stagnating, Japan shrinking

As such, ending yield curve control might boost JPY for two reasons:

  1. It would allow the BoJ to shrink its balance sheet more quickly.
  2. A steeper yield curve could boost economic growth by encouraging bank lending and thereby draw more capital into the yen.

At some point the Fed’s tightening might produce a slowdown in the U.S. while the weaker JPY might boost Japanese growth. If that happens, the growth gap could move in the opposite direction to the benefit of the JPY relative to USD. 

The trade balance

When it comes to trade balances, the U.S. runs consistent capital account surpluses and current account deficits owing largely to the USD’s position as the global reserve currency. As such, because the U.S. runs trade deficits, the rest of the world tends to run trade surpluses and Japan is no exception. The relative size of the U.S. deficits and Japanese surpluses do, however, vary over time. Recently, U.S. deficits have shrunk modestly while the size of Japan’s surplus has come down significantly (Figure 9). The relative size of Japan’s surplus to the U.S. trade deficit has also been a major driver – and sometimes a leading indicator – of movements in JPYUSD (Figure 10). 

Figure 9: Japan’s trade surplus with the U.S. has shrunk

Figure 10: The Japan-U.S. relative trade surplus or deficit can also drive JPYUSD

One of Japan’s major vulnerabilities is that it produces almost none of its own crude oil, natural gas or coal, a weakness that has been exacerbated by the reduction in nuclear power following Fukushima. One of the reasons why Japan’s trade surplus shrank in 2021 and 2022 was the soaring cost of imported energy. Crude oil prices soared as high as $110 per barrel. The Japan-Korea Marker (JKM) price of natural gas soared by 2,000%. Coal prices also rose, especially in 2021. All of these factors contributed to the yen’s dive in 2021 and 2022 versus USD and most other currencies. The fact that JKM natural gas prices have now fallen by over 80% from their highs last year and the global moderation in crude oil and coal prices have also acted to support the yen in recent months. The combination of lower energy prices as well as the beneficial effects of a weaker yen on Japanese exports could give rise to an expansion of Japan’s surpluses which could prove supportive for the yen. 

One final note on JPYUSD: it has a lot of bond-like characteristics. Since 2006, JPYUSD has generally had a strong, positive, if not always stable correlation with the day-to-day price changes in U.S. Treasuries (Figure 11). Since bond prices and yields move in opposite directions, that has meant that JPYUSD tended to fall when U.S. yield rise, and vice versa. As such, if the Fed’s rate hikes tip the U.S. economy into a recession, that could provoke a steep fall in U.S. Treasury yields, which could prove to be very supportive for the yen. Moreover, any sudden reversal in monetary policy with the U.S. lowering rates as Japan tightens, has the potential to provoke an unwinding of carry trades that use the yen as a funding currency, which could, at some point, prompt a sudden strengthening of the yen. 

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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