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Yen bears are just getting started

Mid-morning last Friday, as Tokyo’s foreign-exchange traders were contemplating lunch, the first pictures of Donald Trump meeting the Japanese prime minister, Shinzo Abe, flashed up. The yen bears loved it.

Setting aside the gold-encrusted Babylonian decor of Trump Tower and forced bonhomie, conventional market wisdom before November 9 was that an image like this would send global investors everywhere screaming into haven, long yen positions. Forget an earnings turnround for corporate Japan, and any sense that the Bank of Japan could retain control of the currency. Everyone “knew” a Trump presidency would launch the yen into the stratosphere.

In fact, traders barely had time to come up with a joke caption for the picture before the dollar had lurched another big notch higher against the Japanese currency, continuing its improbable adventure above the key ¥110 line and extending a bull run in the shares of Japanese exporters.

Some, like Nomura’s FX strategist Yunosuke Ikeda, are doubtful the dollar rally can be sustained too much further: the noise on the trading floor suggests a lot of the heavy lifting on the recent dollar-yen move has come from unwinding of hedge funds’ long yen bets and last Friday’s Chicago International Monetary Market data suggest that process has run its course.

As Shusuke Yamada, currency analyst at Bank of America Merrill Lynch, points out, the most abrupt moves in the recent yen weakening run have come after 4pm in Japan — a strong hint that the currency’s course is being set by speculative money and macro hedge funds outside the yen’s home territory.

Fuelling scepticism over the sustainability of the yen’s slide are several potentially dollar-weakening factors on the immediate horizon. Markets have almost completely priced-in an interest-rate increase by the US Federal Reserve next month, which could produce a “sell on fact” trade if that unfolds as expected.

Italy’s December 4 referendum on the constitution could hit market perceptions of eurozone stability and generate another spasm of haven yen buying. Another key risk, says Mr Ikeda, lies in the behaviour of whoever Mr Trump selects as his Treasury secretary. A gentleman’s agreement among G7 members tends to prevent respective heads of foreign currency policy talking openly about specific direction and levels of forex rates, but a new appointee not bound by that until the inauguration in late January could become a source of volatility-inducing comments on the dollar.

Others have taken the weakening of the yen beyond ¥110 as a signal that a new trend of weakness is now in play. Kamal Sharma, a currency strategist at Bank of America Merrill Lynch, says “a president-elect with a different agenda, a growth-supportive manifesto — there is a trend here which is higher dollar-yen in particular … that suggests policy divergence is in play again”.

BAML is not alone. The Tokyo-based FX team at Morgan Stanley UFJ casts long dollar-yen as its top pick and has put a ¥118 target on the trade. So far, that looks smart.

The fast analysis, say traders, is either that the market got it wrong when it decided before the election that a Trump win would mean dollar Armageddon, or that it is mistaken now as it figures the incoming president as a realtor and complacently propels the US currency to greater heights.

Yet the scale of the dollar’s post-election demolition of the yen, compared with other currencies, is surprising. There are no particularly strong implications from a Trump presidency for Japan or Japanese policy, say analysts at RBC Capital Markets, but two factors help explain the yen’s underperformance.

First, dollar-yen has resumed its role as what RBC calls “a proxy for general risk appetite” in what has been a predominantly risk-averse climate. Second, the hedging behaviour of Japanese investors has made the yen one of the most leveraged currency plays on short-term interest rates in the US.

Derek Halpenny at MUFG agrees, up to a point. “The cost of hedging is going to be more expensive,” he says. That means two things — either Japanese investors stay at home more, or they hedge less. Either way, the dollar rises against the yen. But only so far. The year’s end should see the dollar worth as much as ¥113-¥114. But eventually getting to ¥120? “I’m very dubious we can get there,” Mr Halpenny says.

Others argue, though, that the post-US election sessions have disguised fundamental scene shifts that may offer better clues to what will happen next.

The first is that the biggest Japanese investors — the pension funds and life insurers capable of cementing a market move — have not participated in the recent dollar rally. The recent changes, say traders, have been far too lively for their taste and they will probably not step in until calm is restored. For the Japanese heavyweights, a serene dip to ¥108 will probably be the signal to start building long dollar positions.

The second is the recent widening of the spread between US Treasuries and the benchmark 10-year JGB yields to a five-and-a-half-year high after Mr Trump’s meeting with Mr Abe. Analysts highlight the correlation between dollar-yen shifts and the Treasury-JGB spread is firmer than at any time since 2010.

A third, and perhaps decisive, factor was the Bank of Japan’s decision last week to deploy the financial weaponry it granted itself in September when it announced a policy of “yield curve control” on JGBs.

Some suspect that the BoJ will not be able to fight the global trend of rising yields, while others argue the BoJ has given itself a powerful tool and has the advantage that the market is still sceptical the BOJ is capable of generating much inflation anyway.

“If Japan holds the 10-year yield to around zero even as US interest rates rise amid expectations of expansionary fiscal policy in the US, the US-Japan interest rate differential will widen. Holding all else constant, a widening of the interest rate differential would weaken the yen,” says Morgan Stanley MUFG’s Takeshi Yamaguchi.

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