Grokking the Yen

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The strength of the Japanese yen puzzles many observers.   North Korea’s missile test flew over Japan for the first time in a year.  Why would investors buy the yen on such news?

There are two types of buying that may be confused.  There is the normal buying, which is to increase the exposure to a particular instrument.  This is what most people mean when they say “buy.”   However, there is another type of buying.  It is meant to cover a short or a previously sold position.  

The yen and Swiss franc are often used as funding currencies.  In effect, this means the currency is borrowed and then sold, and the proceeds are used to buy a higher yielding or better-performing assets like European or emerging market equities, for example.  As the heightened geopolitical tensions encouraging liquidating the assets, the funding has to be unwound, and this involves buying the previously slow yen and/or franc.

There is some support for this explanation.  Consider speculative positioning in the futures market.  The gross short yen position peaked in mid-July with a little more than 164k contracts (each futures contract is for JPY12.5 mln).  The week ending August 22 was the fifth consecutive week of that the gross short yen position was reduced, and over this period it fell by about 45k contracts.   The gross long position bottomed in late July near 28k contracts and has risen to 45k in the week ending August 22.

Japan’s Ministry of Finance reports portfolio flows on a weekly basis.  Foreign investors do not appear particularly keen to buy Japanese assets.  Foreign investors have been net sellers of Japanese shares for the past four weeks through August 18.  Over this period they sold about JPY800 bln of Japanese shares.    Foreign investors sold Japanese bonds last week for the first time in four weeks.  Over this period they bought about JPY920 bln of Japanese bonds.   This seems more like a shift from stocks to bonds rather than a safe haven demand for yen.

Japanese investors sold foreign bonds for the past two weeks for a total of JPY600 bln.  However, this follows a three-week strong buying spree during which they bought JPY3.85 trillion of foreign bonds.  Japanese investors have been buying small amounts for foreign equities on a weekly basis without fail since mid-May.  Since the sale, Japanese investors have found an average of nearly JPY290 bln of foreign equities a week.  Over the past four weeks, the average slipped to JPY192 bln.  The point is that even Japanese investors do not appear to be materially repatriating the savings they investors offshore.

On a purely directional basis, the dollar-yen exchange rate has become highly correlated with both the S&P 500 and the Dow Jones Stoxx 600.  This is what one would expect to be the case if the yen was used as a funding currency.   Over the past 30-day, the correlation between the yen and the Dow Jones Stoxx 600 is near 0.88.  It was inversely correlated in July and had approached correlation levels in May and June.

The correlation of the S&P 500 and the dollar-yen exchange rate on a directional basis (correlations conducted on the level of the S&P 500 and the dollar) is near 0.82 over the past 30 days.  It had been inverse from early June through mid-August.

The strong correlation between the dollar-yen exchange rate and the S&P 500 and the Dow Jones Stoxx 600 is consistent with what one expects if the yen was used as a funding currency to buy shares.  However, the hypothesis breaks down when it comes to emerging market equities.  The correlation between the dollar-yen exchange rate and the MSCI Emerging Markets equity index -0.25 over the past 30 days and -0.54 over the past 60-days.  One potential explanation is that while the yen is used to fund US and European equity purchases, it is not used to fund emerging market equities. The dollar may be used to fund such purchases.

The JPY108 area held back in April.  Last year the greenback briefly traded below JPY100.  A break of JPY108 would target JPY107.25 initially, but the JPY106.50 area may be of greater technical significance.  The correlation between the dollar-yen exchange rates and US 10-year yield appears more stable and just as strong as with US and European benchmarks (30-day 0.84, 60-day 0.73).  The correlation between the dollar-yen exchange rate and the US 10-year yield is more robust in that the correlation between the percent change of each is also highly correlated ( 30-day 0.84, 60-day 0.75).

Geopolitical anxiety tends to be intense but short-lived.  That seems to be what the price action of the Korean won and Korean equities is suggesting as well.  In the medium and longer-term, the dollar-yen needs higher US interest rates to find better traction.