Forex Forensics: The Case of the Yen

Over the past five sessions, the yen is the strongest of the major currencies, appreciating about 1.7% against the US dollar, eclipsing the Swedish krona, which rallied strongly today after the Riksbank's surprise rate hike.  Given the sell-off in equities and the decline in markets, the yen's strength is not surprising.  What was surprising though was the dollar's resilience against the yen earlier this month as equities began to slide and bond yields fell.

The Ministry of Finance weekly portfolio flow report offers some hint of what may be happening.  There has been a surge of foreign bond buying of Japanese bonds in the first half of December.  It has averaged JPY1.66 trillion (~$1.5 bln a day), three times the similar year-ago period.  The four-week moving average is at its highest level since 2007.   

Japanese investors had been significant buyers of foreign bonds.  In the last week of November and the first week of December, Japanese investors bought an average of JPY1.14 trillion foreign bonds a week.   However, buying dried up.  It is not clear why, and the possible reasons run the gamut approaching year-end, the substantial rally in global bonds that had already been recorded, resulting in low yields, and the proximity of the ECB and FOMC meetings. The relative strength of the yen, at its best level against the dollar and euro since late-October. 

Equity portfolio flows were considerably smaller, but on a net basis were also supportive of the yen.  In the first half of December, foreign investors sold about JPY900 bln of Japanese shares, while Japanese investors sold around JPY175 bln of foreign shares.  

Typically, foreign fixed-income investments carry a high hedge ratio than equity investment.  Currency fluctuations often overwhelm the yield on the fixed-income and dominate the total return.  But in Japan's case, it may work a bit different.  One does not buy Japanese bonds for yield.  Many foreign fixed income fund managers buy JGBs because of their benchmark.  Some asset managers cannot take naked currency exposure, so to express a bullish yen view, a manager would buy a JGB on an unhedged basis.  On the other hand, after increasing unhedged foreign bond purchases, since the start of the second half of the fiscal year, some Japanese asset managers and insurance companies may have begun raising hedges.  This would involve selling the foreign currency and buying yen.  

Some of the foreign buying of Japanese bonds may be part of some large financial trade.  It appeared that Japanese banks acted early to secure their year-end funding.  The JPY/USD three-month cross-currency basis swap (a measure of the accessibility of dollar funding) showed that Japanese investors were paying 60 bp on top of LIBOR to secure dollars for the first half of Q4.  The bulk of the needs appeared to have been met, and the premium Japanese investors paid fell back to 20-25 bp.  

In the CME futures market, speculators have reduced their net short position over the past two weeks ending December 11.  It fell by about 7k contracts (each contract is for JPY1.25 mln) to 97.6k contracts driven mostly by short-covering.  It is the smallest in five weeks. 

In the options market, three-month implied volatility is surging as the dollar appears to be breaking out of its recent range. The put-call skew shows that the premium being paid for dollar puts is the most in three months, which also speaks to hedging considerations that may be as important if not more than the portfolio flows themselves.  

A break of JPY111.40 area sets up a test of the JPY110.70-JPY111.00 area, where important retracement levels and the 200-day moving average are found.  

Disclaimer