More Thoughts about the Yen

new japan

The conventional narrative is that the yen’s strength is being driven by risk.   It seems to border on circular logic.  If the yen is up, it must be due to investors being averse to risk, and we know investors are averse to risk if the yen rise.

As we have done before, we continue to question the narrative which says that in troubled times, the yen is bought as a safe haven.  The flow of funds does not bear this out.  Foreign investors do not flock to Japanese markets when investors are fearful.  Instead, we suggest that the main behavior that changes is Japanese investors themselves.  They are unwilling to recycle the current account surplus, which is derived more from its investment income than trade in goods and services.

The safe haven asset is the US Treasury market.  That has repeatedly been experienced.  Lower US yields weigh on the dollar-yen exchange rate. The correlation (60-day percentage change) between the exchange rate and the US 10-year yield of nearly 0.8, is the upper end of the correlation range since at least 2000.    The correlation with the US two-year yield is a little below the 10-year correlation but is also at the upper end of is range.

There are several factors weighing on US yields.  Last week was an important blow to psychology.  There were three pieces of disappointing news.  The core PCE deflator eased for the third consecutive month.   Auto sales were weaker than expected and this will weigh on headline retail sales and could be a drag on manufacturing.  The jobs report was tepid, even though other labor market readings like the ADP, weekly jobless claims and the ISM suggest no deterioration in the labor market.

Separately, there is also concern that the Trump Administration’s economic program, which helped spur the sharp rise in US yields in the last two months of 2016, do not look as large or as likely as it may have seemed previously.    The seemingly chronic drama and crisis, as well as the investigation into Russia attempt to influence the US election,  saps energy, focus, and attention.  Moreover, the handling of the health care issue seems to have also undermined the confidence in the Administration’s legislative acumen.

There is another factor that may be playing a role, though it may be more difficult to turn it into a sound bite or a tweet.  It has to do with efforts the US Treasury is making to circumvent the debt ceiling which was reached in Q1.  The Treasury appears to have shifted its balances from the Fed.  The apparent shortage of dollars last year has been alleviated, at least until the debt ceiling is lifted.  The White House wants the Republican-led Congress to do so before their summer recess at the end of next month.

That the dollar scarcity has been overcome is evident in the cross-currency basis swaps.  The cross currency swap is a metric of demand for dollars.  There was an increased demand for dollars due to the divergence in monetary policy, less market-making an arbitrage from global banks, and a decline in dollar sales by reserve managers.  Consider that the cross currency one-year swap fell to an 83 bp discount to LIBOR at the end of last November. By the end of Q1 17, the discount to LIBOR was halved to minus 43 bp, the least since September 2015.  It is currently near minus 46 bp.

cross currnecy swap

The chart here shows the one-year cross currency basis swap quoted about LIBOR for the past two years.  The green line is the yen, and the red line is the euro.  Both swaps show a similar pattern, but the yen is considerably more dramatic.  The volatility of the yen basis swap may be related to liquidity, and some may try to draw a link to the BOJ’s massive market presence.   In any event, one hypothesis is that when the debt ceiling is raised, and the Treasury replaces its deposits at the Fed, then the surfeit of dollars turns back into a shortage.

Japanese investors were net sellers of foreign bonds for a three-month stretch beginning in December and running through February.  They were large buyers in March and were flat in April.  They were buyers in May and the second most since last October.   The four-week moving average (weekly MOF flows) is at its highest now since last August of almost JPY925 bln.

Japanese investors have also returned to foreign equity markets.They were sellers of foreign equities in the face of the global rally in the last four months of 2016, but have been buyers consistently this year.  The four-week moving average reached its highest level (~JPY275 bln) in mid-May.  As of the end of May, the four-week average was still elevated almost JPY242 bln.

Foreign investors were sellers of Japanese shares throughout most of the January to March period.  They have turned modest buyers in Q2.  The four-week moving average reached JPY400 bln by late-April but has been trending lower to stand near JPY178 bln in the last week of May.  Foreign investors have been looking at Japanese bonds more favorable since the end of Q1 as well.   In Q1, foreigners bought an average of JPY50 bln of Japanese bonds a week,  In the first two months of Q2, foreign investors bought an average of JPY305 bln Japanese bonds a week.

Large speculators in the CME currency futures carried a net long yen position most of the last year.  It switched to favor shorts a few weeks after the US election.The most recent reporting period covered the week through last Tuesday, and at that time the net short position stood near 52.3k contracts.  It is the second largest net short position after the Canadian dollar.   The combination of the outside down day on the back of the disappointing US jobs report and today’s break of JPY110 likely spurred short-covering in the futures market, which will contain in the CFTC’s Commitment of Traders report that will be released at the end of the week.

A break of the JPY109.20 area would target the late-April low near JPY108.  Below there is JPY107.70, which is the 61.8% retracement of dollar’s recovery off last June’s  test on JPY99.00, and then JPY106.60.  Now, JPY110.50 is needed to stabilize the tone.