The Yen's Puzzling Surge, Explained in One Morgan Stanley Theory

How Much Rally Is Left in the Yen?
  • Japan's currency breaches 108 level for first time since 2014
  • Shrinking real-yield gap buoys yen: Morgan Stanley, SocGen

The yen’s surge this week to the strongest since 2014, which has confounded most currency traders and analysts, may be best explained through the prism of the bond market.

Even with the struggles of the world’s third-biggest economy and expressions of concern by Japanese officials, the yen rallied more than 3 percent against the dollar this week, the most since February. The advance may seem even more improbable when considering Japanese government bond yields are negative for many maturities, ostensibly diminishing the allure of the nation’s currency.

Yet taking into account inflation-adjusted yields on both sides of the Pacific, 10-year Japanese debt has grown more appealing compared with Treasuries, according to Morgan Stanley and Societe Generale SA. And the banks point to this metric -- the narrowing advantage of the U.S. in terms of real yields -- to help explain why the yen is the best-performing major currency against the dollar this month.

"If real yields remain high, it will discourage the export of capital, which all else equal weighs on the dollar against the yen," said Calvin Tse, co-head of U.S. currency strategy for Morgan Stanley in New York. The bank forecasts the dollar will drop to 105 yen by the end of September.

The yen ended the week at 108.07 per dollar, after reaching 107.67 Thursday, its strongest since before Japan unexpectedly boosted its monetary stimulus program on Oct. 31, 2014. It surged more than 2 percent this week against major currencies.

Currency Check: What's in Store for the Yen?

Consensus Confounded

Japan’s currency has gained about 11 percent this year, in defiance of the consensus on Wall Street at the start of 2016. The median forecast among analysts surveyed by Bloomberg in early January was for the yen to weaken to 124 per dollar by the end of March.

Next week may offer more signs Japan’s economy is struggling. Forecasts call for reports to show year-over-year declines in machinery orders in February and producer prices for March. Sentiment among Japan’s large manufacturers was the weakest since mid-2013, the latest quarterly Bank of Japan survey showed.

Traders Shrug

Officials voiced warnings this week against the yen’s advance, which erodes the competitiveness of Japanese exports.

Japanese Finance Minister Taro Aso said rapid moves in the currency are undesirable, while Chief Cabinet Secretary Yoshihide Suga weighed in on the issue as well. Sparking skepticism, though, Prime Minister Shinzo Abe pledged to avoid “arbitrary” intervention.

Speculators in the futures market still ratcheted up bets on yen gains.

Hedge funds and money managers increased net bullish positions on the yen, according to data from the Commodity Futures Trading Commission. Net bets that the yen would appreciate tallied about 60,000 contracts for the week ended April 5, close to the highest since 2008.

“The yen’s recent strength has been driven by tumbling Japanese inflation expectations, which have driven real Japanese yields higher against both U.S. and European ones, even as nominal Japanese yields fall into negative territory,” Alvin T. Tan, a London-based strategist at SocGen, wrote in an April 7 report. “There is thus a fundamental momentum to the yen’s rise, at least in the near term.”

As expectations for long-term inflation have declined in Japan, its real yields have risen. The extra real yield on 10-year U.S. debt over Japanese counterparts has shrunk to about 0.6 percentage point from about 1.1 percentage points at the start of the year, data compiled by Bloomberg show.

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