Japanese Yen’s Drop Could Indicate Market Trouble

Japanese Yen’s Drop Could Indicate Market Trouble

The Japanese yen has dropped 12% against the U.S. dollar so far in 2022 to hit a 20-year low. That could be a risk to markets far beyond Tokyo, such as the U.S. Treasury market, contends an article in The Wall Street Journal.

Historically, the yen tends to drop when markets rally, and strengthen when things get volatile. But that pattern has twisted around this spring with such a steep drop that it’s now the worst-performing currency out of the 41 currencies that are tracked by the Journal—even worse than the Russian ruble. As the third-most-traded currency in the world, the yen is instrumental in global finance; the Fed, for example, is relying on Japanese institutions to buy up the excess of Treasurys on the market as it winds down its bond-buying program. Given that the yen has fallen so much, those Japanese investors—normally the largest block of foreign buyers of U.S. Treasurys—can’t be counted on now that they will have to pay more, the article maintains.

Now that hedging on U.S. Treasurys has lost its currency protection for Japanese investors, there’s only a 0.2 percentage point difference between a 10-year Treasury yield and a 10-year Japanese bond yield. That minuscule difference makes it more likely that Japanese institutions will turn to ultralong-term Japanese government bonds in their portfolios instead of American assets. While some Japanese investors might try to bypass elevated hedging costs by eliminating utilizing protection currency fluctuations, that move comes with the risk of a yield advantage disintegrating if the yen were to suddenly rally against the dollar, the article explains.

And in fact, Japanese investors have been cutting back on on their foreign bond holdings since last year; in March, they sold off a net 2.36 trillion yen ($18.4 billion) in overseas bonds. U.S. bond sell-offs could ricochet in other markets: if the yield goes up too much, stocks could tumble, as happened in early 2021.

Unless Japan switches gears, many analysts believe the yen will keep dropping, and many hedge funds are betting on that; net positions against the currency hit their highest point in 3 years.  Though the Bank of Japan could raise rates earlier than expected, some investors don’t believe the Japanese government will step in, especially since inflation hasn’t risen enough in Japan for the central bank there to raise rates. But as the yen continues to fall, investors seem content to watch its movements and wait to place bets on whether it rises or falls even further.