Japan's Warning on Yen Reveals Next Big Trade in Swaps

  • Five-year swap spread would widen on intervention, BofA says
  • Spreads dove in 2015 as central banks unloaded Treasuries

With Japan’s finance minister warning about potential intervention to weaken the yen for the first time since 2011, Bank of America Corp. strategists see a way to profit through interest-rate derivatives.

Past episodes of yen sales by Japan led to a buildup of dollar cash and purchasing of Treasuries as some of the money was plowed into U.S. government debt, according to Bank of America. Should Japan intervene again, traders can capitalize by wagering that the added demand for Treasuries will depress yields relative to swap rates, the primary dealer said in a May 6 note.

The yen weakened Tuesday after Finance Minister Taro Aso said the government can act to stabilize foreign-exchange markets if necessary. Speaking in parliament, Aso reiterated that the U.S. doesn’t object to the Asian nation’s policy. On Monday, he said “it’s natural that Japan has means to intervene” in currencies.

“Once the Ministry of Finance intervenes, foreign participation in Treasury auctions and buying in the secondary market increases pretty sizably immediately afterward,” Shyam Rajan, head of U.S. rates strategy in New York at Bank of America, said in an interview. “And over the last year, it was made clear that these types of demand-supply shocks in the Treasury market are not traded best through rate levels, but through swap spreads.”

The last time Japan sold yen to curb gains was in a multilateral intervention following the devastating earthquake and tsunami. The currency has gained 10.5 percent this year, reaching 105.55 per dollar this month, the strongest since October 2014, after the Bank of Japan unexpectedly refrained from boosting stimulus. A strengthening yen undermines the central bank’s efforts to bolster the world’s third-biggest economy.

The dollar bought about 108.80 yen as of 8:25 a.m. Wednesday in New York. Intervention becomes more likely as the yen approaches 100 per dollar, Rajan said.

The potential scenario that Bank of America foresees in swap spreads would be the reverse of what happened last year. Swap spreads plunged for months in part on signs that global reserve managers led by China were selling U.S. debt as they drew down reserves to stabilize weakening currencies.

The swap spread is the gap between the rate to exchange fixed payments for floating ones, and the yield on similar-maturity Treasuries.

Norm Upended

The historical norm had been for that gap to be positive -- indicating traders perceived the banking-sector credit risk inherent in swaps to be greater than that of the U.S. government. That relationship was first upended in longer maturities after the financial crisis, and negative swap spreads became pervasive last year.

Swap spreads on five- through 30-year maturities are now negative. The five-year spread, at about negative 4 basis points, has widened from a record low of negative 12.06 basis points in November.

For its analysis, Bank of America looked at Japanese intervention in 2003-2004, 2010 and 2011. It found that the majority of Treasuries purchased as a result had maturities greater than a year, and it recommended wagering specifically that the five-year swap spread will widen.

“If we get the yen intervention then we will get a positive demand shock from an investor that has a lot of balance sheet,” Rajan said. “That’s why we think it’s best traded through swap spreads.”

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