The Yen is in Deep Trouble

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I’m going to let everyone in on a little secret. On the world’s major trading floors, no one has any clue what direction exchange rates will move in over the next year or two. There’ll be lots of discussion and debate on this, but - honestly - that’s just intellectual jousting and a waste of time. It’s one of those “the blind leading the blind” situations.

That’s not to say FX traders are clueless. Not at all. When you sit in front of a bunch of screens all day and watch currencies move, you develop a feel for the market. You sense what currencies feel “soft” and are about to go down versus ones that look like they’re about to appreciate. A lot of this “feel” is gleaned from how currencies trade around key turning points and this week is one of those for the Yen.

In the run-up to this week, markets had been incredibly hawkish on the Fed, pricing more than one hike through the end of the year. That got right-sized this week with a series of dovish inflation prints, causing rate hike expectations to pull back sharply. This should be a setting where the Yen rallies versus the Dollar, because US rates are falling relative to Japanese ones, but that didn’t happen. The Yen continued to fall, which is a really worrying sign.

The chart above shows daily data for $/JPY during this year’s three intervention episodes. I’ve lined things up in event time, which means that in each episode t is the day before intervention happens. The vertical gray dotted line marks this day. The red line is $/JPY in the first intervention episode, which is the NY Fed’s rate check on Jan. 23. The blue line is $/JPY in the second episode, which is Japan’s very big, unilateral intervention on Apr. 30. The black line is the most recent episode, which began on Jul. 30. I’ve denoted yesterday (Aug. 13) as 8/13.

The Yen has fallen steadily since the immediate aftermath of intervention, including this week. That should set off alarm bells - and surely is on trading floors - because it shouldn’t be doing that. This week’s dovish US inflation data caused markets to scale back their expectations for the Fed to hike, which should be lifting the Yen versus the Dollar. The chart below mirrors the format of the chart above, except that it plots the differential of the 2-year government bond yield in Japan versus the 2-year Treasury yield. The black line - this differential into and after the most recent intervention - is rising sharply, which is the impact of this week’s dovish inflation surprises. The fact that the Yen can’t rally with this kind of tailwind is extremely concerning.

Japan needs a profound rethink on the Yen. Intervention clearly isn’t working to stabilize the Yen, which is consistent with all the historical evidence. What’s needed is a profound shift in BoJ policy. I’m not talking about a 25 basis point hike at the next meeting, which will be irrelevant for the Yen. What matters for the currency are long-term rate differentials, so it’s longer-term JGB yields that need to rise towards their “shadow yield” levels. BoJ buying of government bonds needs to be scaled back so that this can happen. That’s the only thing that will strengthen the Yen.