Yield Differentials Need to Turn for the Yen to Weaken
The Yen continues to face both headwinds and tail winds as forex traders look ahead to both the Bank of Japan and the Federal Reserve meetings which are scheduled to begin on September 20. While changes to policy are in doubt for both G3 central banks, the Fed is poised to tighten, while the Bank of Japan is likely to ease policy. The 10-year yield differential has moved in favor of the greenback during the second week of September after tumbling in the wake of the softer than expected U.S. jobs report.
Despite the weakness in the Japanese economy, yields have moved significantly higher in Japan since the 10-year yield hit a low of -28 basis points in late July. The JGB is now at -1 basis points which led to the decline in the yield differential between the U.S. and Japan over the past 6-weeks.
Fed speak has been volatile. Ahead of the blackout period for the Federal Reserve meeting, both hawks and doves have expressed their view, and that has generated volatility in the currency and equity markets. Sharp swings in U.S. equities have boosted bond yields as investors forecast a potential rate hike by the FOMC on September 21.
The yield differential is a driving force behind the movements of a currency pair because it is directly incorporated into the forward rate. That means if you decide to purchase the USD/JPY for a period longer than 2-days, you will receive interest for holding the higher yielding dollar over the lower yielding yen.
The USD/JPY has been volatile as traders reassess the Bank of Japan’s policy following a report by the Nikkei that discussed that the Bank of Japan is considering taking interest rates deeper into negative territory. While the BoJ adoption of NIRP (near zero interest rate policy) in January failed in its intention to weaken the yen, there is a narrative in the market that a further move might be more effective at the current juncture given the rising prospects for Fed tightening and reducing odds for further ECB easing.
The Nikkei report follows other reports saying that the BoJ is studying options to steepen the bond yield curve, aiming to achieve this by being more flexible in its purchasing program. For the yen to fully begin to recover relative to the greenback, the Bank of Japan will need to push long term yields back down to the -20’s, allowing the yield differential between the yen and the dollar to recover back to the highs seen early in 2016 near 2%. With a 2% yield differential it will become very expensive to remain long the yen, and would provide the backdrop for a higher currency pair. A weaker yen would then potentially lead to stronger exports and a growing economy.
Another hurdle facing the BoJ is U.S. economic data. While the Fed was poised to raise rates ahead of the release of August data, the weakness in manufacturing and jobs data, has capped the upside in the greenback. A Fed rate hike in September would go a long way toward helping the yen weaken.