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Yen Trends as Fed Eyes Rate Hikes By Ilya Spivak
his writer has argued in the past two issues of Luckbox that structural factors beyond “base effects” of the COVID-19 slump in 2020 were likely to make this year’s inflation pick-up stickier than the “transitory” rise envisioned by the Federal Reserve. The Fed seemed to revise its stance accordingly at June’s momentous Federal Open Market Committee meeting. Officials said they were shifting the timeline for an upcoming interest rate hike because price growth had surpassed expectations. Having previously anticipated keeping rates flat through 2023, Fed officials now pencil in two rate hikes that year. The priced-in market view implied in Fed Funds futures following the announcement is more aggressive still, envisioning one hike in 2022 and two more in the following year. It’s not surprising that this pivot drove up near-term borrowing costs and sent the dollar sharply higher against other major currencies.
T
The rising yen A near-parallel rise in the Japanese yen is perhaps a bit more surprising. The Bank of Japan has maintained an ultra-dovish policy stance for the better part of 30 years amid an epic—and mostly fruitless—struggle to bring price growth up to the target of 2%. A rise in borrowing costs worldwide led by the Federal Reserve, which usually sets the overall trend because of the dollar’s ubiquity as the global medium of exchange, may have been seen as yen-negative. That’s because the yen serves as investors’ go-to “funding currency” of choice. Because rates in Japan have been so low, traders popularized a “carry trade” strategy of borrowing cheaply in yen to buy higher-yielding assets and thereby extracting the differential as an
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Dovish Japan? Because most nominal rates have converged near zero, the size of the inflation haircut has become pivotal. Five-year Real Yield (%)
Spread vs. Japan (bps)
United Kingdon
-2.938
-260.0
Germany
-1.750
-141.2
United States
-1.593
-125.5
Australia
-0.962
-62.4
Japan
-0.338
0
Five-Year Breakeven Inflation (%) Inflation expectations in Japan are relatively low compared with its global counterparts.
Japan Germany
0.25 1.17
Canada US UK
1.96 2.47 3.28 Source: Bloomberg
income stream. That approach works best when interest rates are on the rise globally, growing the yield disparities available to exploit. A more hawkish Fed portends just that. The difference this time seems to be that global policy rates have converged on Japan— moving toward zero and sometimes beyond it into negative territory—collapsing yield spreads. Recovering from these depths in most places is expected to come together with reflation. Indeed, as the Fed has made apparent, that’s the driver of the latest outlook change. However, that does not mean that the structural forces holding down prices in Japan for
decades have evaporated. So, real interest rates, the nominal yields discounted by the rate of inflation, have turned out to be higher in Japan than most major economies. Because most nominal rates have converged near zero, the size of the inflation haircut has become pivotal. It’s inherently small in Japan relative to global counterparts, so the inflation-adjusted yield to be had on yen-denominated holdings has emerged as more attractive. It’s the old “carry trade” upside down. Rising borrowing costs Dovish action from the Bank of Japan (BOJ) is an obvious counter to this narrative. Gover-
Luckbox | August/September 2021
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