The Enigmatic Yen–It is More than an Equity Story

Last year was the fourth consecutive year that the yen fell against the dollar.   However, what is obscured by this factoid is that over the past  six months, the yen has been the strongest of the major currencies, rising almost 3.2% against the US dollar.

While some may be tempted to attribute the yen's strength to the dismal start of the year for equities, the fact of the matter is that the yen's strength began before this week.  Recall that 48 hours after the Fed hiked rates last month, the BOJ announced some largely operational adjustments to its asset purchase program.  The explicit goal was to sustain the asset purchases, and this included extended the duration of government bonds being bought.

The BOJ announced that it would buy more equities (ETFs) as well.  This prompted a brief reaction that was unwound when it was realized that the new shares being bought was to offset the shares the BOJ would sell as it facilitated the unwinding of bank cross shareholding.

The dollar initially rally to near the multi-year highs set in mid-November near JPY123.75, but quickly reversed and fell to nearly JPY121.    The greenback has trended lower since.    On Christmas Eve, the dollar was sold through the uptrend line connecting the spike lows in August (~JPY116.20) and mid-October (~JPY118).  It has been unable to resurface above that trend line.  It is now found near the 20-day moving average (~JPY120.85).

Although in the past, extending maturities of bonds being purchased by a central bank was considered easing, this time is seen differently.    It was seen as a sign of the BOJ reluctance to step up it efforts.  The IMF, among others, has warned that the BOJ's QQE is not sustainable at the current pace.  The IMF examined the capital requirements of Japanese banks, insurers and pension funds and concluded the BOJ would have to start tapering in 2017 or 2018.  Some media reports cite others thinking the current program would have to be adjusted by the end of this year.

Many had expected the BOJ to expand its unorthodox policies last year, and kept pushing out in time when it would materialize.  After the BOJ's move last month, many now seem to be concluding its efforts will not be accelerated.   Indeed, Prime Minister Abe is coming close to declaring "mission accomplished", saying recently that the goal of beating deflation is within reach.  BOJ's Kuroda has been quoted on the news wires today, opining that current policy-setting s should be sufficient to reach the inflation target.  That said, the Nikkei has reported that the BOJ is considering cutting the inflation forecast for the next fiscal year to 1.0% from 1.4%.

 In contrast, the ECB eased policy (extended its asset purchases program and cut the deposit rate to minus 30 bp) and many suspect more is likely to be delivered.    Since the BOJ's announcement, dollar-yen has fallen 4.0% while euro-yen has fallen 4.5%.

The dollar-yen and the S&P 500 were highly correlated, but that relationship has weakened since mid-November.  We look at the correlation based on the percentage change of each over the past sixty sessions.  In August the correlation reached its highest level since 2008 near 0.80.   As recently as early-November is was still near 0.75.  It fell to 0.35 in early-December, its lowest level since July.  Today it is near 0.49.

On a purely directional basis, running the correlation on the value of the dollar-yen and value of the S&P 500, the relationships has also loosened.  We looked at the last 100-session results.  The correlation peaked last year in the middle of October near 0.90.  Today it stands at a three-month low near 0.68.

Another frequent driver of the dollar-yen exchange rate is interest rate differentials.  The  premium the US pays on two-year and 10-year government borrowings reached the highs for 2015 at the very end of last year.  The 110 bp premium on two-year notes was the widest since 2008.   It is around 103 bp today.   The 10-year premium rose to almost 204 bp at the end of last year, and is just below 200 bp now.    Interest rate differentials look to still be supportive for the dollar.

Japanese investors typically prefer buying foreign bonds to foreign equity.  However, this seemed to change starting in late November. Over the four-week period ending December 18, Japanese investors bought a little less than JPY400 bln of foreign bonds and bought a little more than JPY500 bln of foreign equities.

For their part, foreign investors typically prefer Japanese stocks to bonds.  However, in the last four weeks, this pattern has changed as well.  In the four weeks through December 18, foreign investors bought nearly JPY1.1 trillion of Japanese bonds, and sold JPY665 bln of Japanese stocks. We suspect year-end considerations played a role in these shifting patterns, but will closely monitor the weekly MOF reports.

Speculators in the CME currency futures have dramatically reduced their gross short yen exposure.  Speculators were short 113k contracts (each contract is for 12.5 mln yen) in mid-November.  The gross short position stood at 62.2k contracts as of December 29.    The gross long speculative position fell to about 26.4k contracts in early December, which was the lowest level since last February.  In the following three weeks, it jumped to 45k contracts, a two-month high.

Although last week, when it had appeared that the dollar would hold above JPY120, the technical condition looked more supportive of picking a bottom.  However, the damage inflicted by yesterday's decline leaves us somewhat less sanguine over the near-term outlook.  We had anticipated that a strong US employment report at the end of the week would strengthen expectations of another Fed hike in late Q1.  However, as we noted the interest rate differentials appear to be more dollar-supportive than prices reflect.  A convincing break of Monday's low near JPY118.70 could spur a quick move toward JPY118.00.  A break of that could be ominous as there is little chart support until closer to JPY116.