After strengthening sharply over the majority of the year, the Japanese Yen has now settled into a weakening trend brought about by the election of Donald Trump as the new US President alongside rising global bond yields.
JPY strength over the first 9 months of the year was largely responsible for downward pressure on global bond yields creating a negative feedback loop whereby JPY strength subdued domestic inflation expectations and made the BOJ’s QE program seem ineffective. This, in turn, fueled expectations that the BOJ would have to employ yet further, more unconventional action, in a bid to combat deflation. Each time the BOJ disappointed markets JPY then strengthened and domestic investor confidence plummeted.
Japanese QE drove more domestic purchases of foreign bonds as yields fell below zero, placing further downward pressure on global yields and thus creating less yield disadvantage for JPY. The deterioration in global confidence in the effectiveness of low yield’s ability to stimulate growth fuelled large safe-haven demand for the Yen with the search for yield causing strength in higher yielding currencies such as NZD. Alongside this we saw falling domestic inflation expectations raising real yields in Japan which leant further support to the Yen.
BOJ Breaking The Cycle
It now appears that this negative feedback loop has finally been dismantled. The BOJ have shifted their emphasis onto yield curve control which so far seems to be working effectively in an environment of rising global yields. As yields strengthen, the BOJ can purchase more bonds as well as increase the duration of their purchases and can even start to sell shorter-term bonds to purchases longer-term bonds. Consequently, the USD/JPY 10y yields advantage has spiked to now testing the 2013 high whilst the 2y yield spread is at its highest level since 2008.
The cap in domestic yields alongside a weaker currency are likely to fuel an increase In Japanese inflation expectations and a decrease in real yields. Consequently, monetary policy now appears to be working much more effectively, and there no longer appears to be a problem for the BOJ in sourcing bonds to meet its QE purchase target.
