Is Yen’s Decline Over?

Yen Rebound Helped Kuroda Defeat Bond Market Vigilantes

Predictions are hard, especially ones about the future. So said Yogi Berra. That’s why traders in currency and bond markets lost untold billions on bets that the ¥/$ exchange rate would keep weakening toward ¥140-150/$ (a higher number means a weaker yen). Instead, the yen hit a low of ¥139 on July 14, has since rebounded to ¥133, and new polls of analyst forecasts have yet to be released. At the same time, traders also lost big on a bet that they could defeat the Bank of Japan’s (BOJ) efforts to keep the interest rate on 10-year government bonds (JGBs) from going above 0.25%. Instead, the JGB rate has now retreated to 0.18%.

These two bets were linked. Traders believed that, if the yen kept sinking like a stone, the BOJ would be forced to raise interest rates. The latter would slow the flow of money out of Japan to markets like the US, where rates are higher and still rising. Traders reasoned that the BOJ would eventually have to respond to the damage caused by an excessively weak yen. The purchasing power of the yen in international trade is back down to a level last seen a half-century ago and the resulting increase in prices of import-sensitive items, like food and energy, is hurting households.

The battle came to a head in mid-June when the BOJ pledged to spend an unlimited amount of money to buy JGBs at the 0.25% interest rate. It had to spend an unprecedented $80 billion in the course of just one week. In the end, the BOJ won and traders who sold the yen short[1] are now being compelled to buy yen at a higher price in order to cut their losses. Once again, betting on a JGB crash was what traders call “a widow-maker,” a nickname for a bet that causes them to lose enormous amounts of money.

Why The Bets Lost: Change in US Outlook

Surprising as it may seem, traders lost money in Japan in large part because they guessed wrong on American interest rates. They foresaw long-term rates in the US continuing to climb whereas they have instead fallen back a bit.

Over the past year, the gap in interest rates between the US 10-year Treasury bond and the 10-year JGB has been the single biggest factor in causing the yen to weaken (see chart at the top of this post). Since Japanese rates are so close to zero, it is the gyrations in US rates that have the most impact on the size of the rate gap.

Moreover, US and Japanese rates have also been moving in tandem over the past year (see chart below). Hence, traders figured that, since US rates are rising, Japanese rates would sooner or later have to follow.

However, the US Federal Reserve has been having quicker success on the inflation front than analysts and traders expected just a few weeks ago. That’s partly because its strong and swift actions have already weakened the economy, causing two negative quarters of GDP in a row. A drop in GDP tends to lower inflation through the law of supply and demand.

As a result of all this, the interest rate picture has greatly changed since June.

First of all, the 10-year US Treasury bond interest rate peaked at 3.5% on June 14. Since then, rates have fallen substantially and, as I write, are now at 2.65%. At the end of March, bond market expectations of annual inflation over the coming 5 years peaked at 3.6%. As of yesterday, expected inflation had fallen by almost 1 percentage point to 2.7%, while expectations for six-to-ten years from now are at 2.3%. While these rates are still a distance from the Fed’s goal of 2%, they never got close to headline inflation—9% in the June report—and are falling rather than rising. In short, bond traders believe that strong Fed action is successfully preventing that stratospheric level of inflation from embedding itself in the economy.

As a result, the market believes that the Fed does not have to raise interest rates as high, or for as long, as previously foreseen. The interest rate that the Fed directly controls is the overnight rate, also known as Fed Funds. The “futures market” now sees the Fed funds rate peaking in January 2023 at 3.4% and the Fed lowering it to 3.34% by March. Back in June, bond market traders saw the Fed funds hitting 4%, and the Fed not cutting rates until later in the year. The current rate is 2.25-2.50%.

I’m much better at forecasting the past than the future, so I don’t even try. What I can do is report a big change in mood among those who make their living based on how well they see the future.

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[1] Selling something “short” means selling an asset you don’t yet own in the expectation that you can reap profits by buying it later after the price has fallen.