YEN: the sunset of the rising sun?

The strong weakness of the Japanese currency (JPY) against the major currencies (USD$ and Euro especially) has taken many traders by surprise.

The surprise probably comes from the fact that the yen, historically, ihas been considered a currency that in phases of market volatility (risk off) tends to appreciate. If we look in particular at the dollar yen cross, it is easy to remember the good upward behavior of the japanese currency against the US one in the great crisis of 2008-2009, during the european sovereign debt crisis of 2011 and, in 2020 during the Covid19 period.

In this phase of the downturn in the financial markets, the depreciation of the yen therefore appears anomalous. But what is actually happening?

In a previous article we illustrated how the value of a currency in the medium to long term is a function of a series of variables, the main ones being the economic growth prospects to which the currency refers and the political risk (country risk) of the country in question.

It should be remembered that when analyzing a cross exchange rate between two currencies, we are talking about a relative relationship, that is, a relative strength between one currency and another (in this case yen against dollar, in acronym JPYUSD).

The relative logic here is very important because in the cross we have to compare both the economic outlook and the relative country risks.

Let’s start with country risk. There is a market instrument, the CDS (Credit Default Swap) that we could use as a proxy for country risk. The CDS is a contract between two parties where one pays a premium (expressed in basis points) to protect itself / insure itself from the risk of default (Credit Event) of an issuer (in this case the reference country) for a certain period of time (the standard maturity is 5 years), while the other party collects the premium and, in fact, plays the role of the insurer in the event of default.

The cost of insurance against Japan’s 5-year default risk (Japan 5yrs CDS) is now around + 20bps. For the United States we are talking about + 18bps. This information has two implications: the first is that the market today does not perceive the default risk as a probable event for both macro-areas (both premiums are very low); second, the two risks are perceived by the market as very similar and therefore, at this time, they are not differential in determining the price of the USDJPY cross (+ 20bps – 18bps = + 2bps there is practically indifference)

As regards the second aspect (future growth prospects), the market instruments that are usually used to analyze the expectations that the market has regarding the two macro-areas under analysis (Japan and USA) are the real rates implicit in the returns of the respective ten-year government bonds (10yrs JGB and 10yrs US TSY).

The below chart shows JPYUSD trend (blue series on the left scale) with the delta between the implicit real rates of the 10yr japanese and american yield (red series on the right scale) in the last two years.

In the chart it is possible to notice a certain stability of the JPYUSD cross between 103 and 111 from May 2020 to September 2021 and then a strong dollar upward movement of up to 135 JPYUSD (today it takes 135 yen to buy one dollar).

What caused this movement? In the first period (from May 2020 to September 2021) the monetary policy stance of both central banks (FED and BOJ) was very similar and expansionary. Conversely, from the end of 2021 to today the strong and sudden change in the monetary policy choices of the Fed, in contrast with the substantial immobility of the BOJ, has violently discharged on the dollar yen exchange rate.

In fact, since November, the real implicit rate in the 10yr JBG has gone from – 40bps to – 70bps (= -30bps). In the same period, the respective real rate in the 10yr US TSY went from -100 bps to + 60bps (= + 160bps). Therefore – 30 – (+ 160bps) = -30 – 160 = -190 bps. The red series (on the right-hand scale) shows the delta of japanese real rates against american ones (we went from +45 to -145 = -190bps).

There is therefore 190 bps of difference in real implied rates in favor of the 10yr US TSY compared to the same 10yr JGB in Japan. The point is that the delta of the real rates of the two government bonds represents the delta of expectations of a rise that the market has regarding the hikes in American rates compared to the japanese ones (in a forced way we use here the delta implicit real rates as a sort of proxy of the growth expectations of the macro-areas under analysis).

It is therefore this strong difference in expectations that the market has on the next moves of the two central banks that has determined the sharp depreciation of the japanese currency in the last seven months. The point is that, if we believe we are at the Fed’s highs of upside and at the same time as the BOJ’s lows, the yen would probably no longer have to sell against the dollar today.

JPYUSD vs Japan – US RR (Real Rates)