Trading Yen in the Era of the Hawk Requires a Look Back in Time

  • Yen’s link with interest rates strongest in at least 10 years
  • Rate normalization will fuel yen selling, says Oanda’s Innes

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Central bank policy has always mattered to the yen, but it hasn’t mattered this much for at least a decade.

As the steadfast doves at the Bank of Japan come up against the pivot to hawkishness elsewhere, the yen is rediscovering its pre-financial crisis self -- when a thirst for carry trades saw the currency depreciate amid demand for higher-yielding counterparts like the Australian and New Zealand dollars.

Analysis using Bloomberg terminal functions shows the correlation between yen exchange rates and borrowing costs has crept up to the highest level since at least 2007. That may go some way to explaining the currency’s about-turn, switching from gains versus most major peers in the first quarter, to losses against all but South Africa’s rand the past month.

With the Federal Reserve well into its rate-hike cycle, the European Central Bank signaling its intention to pare stimulus, and policy makers elsewhere mulling tightening, investors like Ray Dalio are already calling time on the era of easy central bank money -- read more on that here.

That means the BOJ is starting to look isolated, with Governor Haruhiko Kuroda maintaining stimulus efforts by intervening to cap gains in the country’s bond yields.

After collapsing in 2013 as central banks around the world reduced the cost of borrowing to stimulate their beleaguered economies, the correlation between yen declines and wider interest-rate spreads has recovered. It’s now stronger than it was before the financial crisis.

“It’s all about developed market policy normalization, this is the primary reason why this correlation holds true,” said Stephen Innes, a senior Asia-Pacific currency trader at Oanda Corp. in Singapore. “With other central banks waxing hawkish, it has the natural tendency to underpin the dollar-yen rate due to yen selling on the cross.”

Haven Trade

Bloomberg’s analysis involved tracking an index of the yen’s moves versus dollar, pound, euro and the Aussie alongside the two-year interest-rate swap spread between the four currencies and the yen. The yen’s key exchange rates and interest rates had a correlation of 68 percent at the end of June, the data show.

For more on how this was calculated, see: Functions for the Markets.

While rate differentials may be growing in influence for the yen, bullish global growth expectations are also weighing on the currency, according to Nicholas Smith, a strategist at CLSA in Tokyo.

“The yen also weakens because of the unwinding of the safe haven trade,” he said.

— With assistance by Bogdan Ciobanu, Sandy Hendry, and Narae Kim

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