Bank of Japan Governor Haruhiko Kuroda

The BoJ’s decision was not portrayed as a tightening of policy but more as an attempt to breathe some life into the beleaguered JGB market given that 10-year yields had been stuck near the previous limit  of 0.25% and the bonds had become virtually untraded. The change in policy won’t breathe life into the JGB market; rather, it will just mean that 10-year yields become stuck at 0.5% rather than 0.25%. But that’s still 25 basis points of extra yield for the yen bulls to get excited about, and they certainly got excited yesterday as the yen surged.

The problem for the yen bulls, in our view, is that there really is no relationship of note between JGB yields and the yen, nor is there any relationship between the level of JGB yields and foreign inflows into the Japanese bond market. If there seems to be a lack of correlation between 10-year yield spreads and dollar/yen, for instance, it's often put down to the fact that hedging costs are key because many investors will hedge their bond holdings.

If you do this, then the current 3.15% 10-year interest advantage in the US turns into a deficit of more than 1.5% when the dollar and yen are hedged on a 3-month rolling basis. This is because the Fed has aggressively hiked policy rates and forced short-term cash rates higher. But even when you include currency hedging, there is really no clear relationship at all between hedged yield differentials and the dollar and yen.

Most of this year has seen the dollar soar against the yen, but over all of this period, the yen-hedged return from Treasury bills has been falling compared to that for JGBs. So, while we could argue that it’s not the JGB yield that is key here but instead Fed policy and the cost of hedging, it is still not clear that it gets you any closer to knowing where the dollar and yen will go.

The Fed could, for example, start to ease policy next year, and the hedge cost for Japanese investors could come down as a result, prompting more demand for Treasury bonds from Japanese investors and less JGB demand from dollar-based investors. Of course, if all of this demand is hedged, the dollar-yen spot rate should remain stable.

The key is whether changes in hedging costs cause investors to move from hedged to unhedged positions or the other way around. For instance, if the hedged return from US treasuries starts to decline for Japanese investors because the Fed starts to ease, then potential buyers could switch to unhedged JGB purchases and so help lift the dollar/yen.

The bottom line is that any relationship between rates and the dollar or yen is quite complicated. If any more evidence was needed, just think about policy changes. For example, the dollar/yen has risen from around 115 to a peak of 150 during this Fed tightening cycle, but during the previous cycle between late 2015 and late 2018, the dollar/yen fell from 120 to a low of 100 before recovering to around 112 by the end of the Fed's cycle.

Perhaps unsurprisingly, we’re not going to get too carried away by the extra 25 basis points that the BoJ appears to have added to 10-year JGB yields. In recent weeks, we’ve put forward alternative arguments for what makes the yen move. These include the observation that high levels of domestic savings in Japan make Japanese banks and investors huge lenders to the rest of the world. Some of the funding for this lending comes from the FX swap market, where banks and investors borrow dollars. But if the assets acquired turn sour, as has been the case this year, banks and investors become overhedged or too short of dollars and can adjust for this by buying dollars in the spot market.

What it means is that the yen is more sensitive to the performance of global assets, with the yen likely to be weak when asset prices are pressured and stronger at other times. If this is correct, it means that yen strength is certainly not guaranteed in 2023, particularly if higher Japanese rates lift global risk aversion even more.