The yen has fallen the most of all the developed currencies in 2022

>> What currencies could surprise us in 2023?

It has been a year to forget for many assets: stocks, bonds, and non-dollar currencies. The yen has fallen the most of all the developed currencies, and the vast majority of opinion puts this down to the divergence between monetary policy at the Fed and the BoJ. There might also be some blame put on Japan’s high dependency on energy imports and the resultant weakness in the terms of trade. But we have problems with both of these arguments, and this could be important in trying to determine whether 2023 will be another year to forget for the yen as well.

It is easy to blame Fed policy for the yen’s woes, particularly as the BoJ is the only developed-country central bank that has not hiked rates. But we have some problems with this explanation. For a start, the dollar and yen might have risen during the current Fed tightening cycle, but they did not during the last one between late 2015 and 2018. In fact, the dollar/yen started this cycle around 120 and ended it close to 110. If dollar/yen seems to follow rate differentials during one Fed cycle but not the other, it probably suggests that there’s no relationship there at all—and statistical analysis would tend to back this up.

"Another problem we have with this explanation is that the aggressive Fed rate hikes this year have contributed in a big way to the substantial risk-off sentiment in the market." Normally such risk-off episodes lift the yen, not lower it, and usually because yen-funded carry trades are quickly unwound. Japan’s energy dependency and consequent fall in the terms of trade this year do not really stack up as a good reason for yen weakness either. "This is because the yen has fallen across all currencies, sliding some 10% against the euro, for instance, whose terms of trade took a much bigger hit from the Russian invasion given the region’s huge dependency on Russian gas imports," said Mr. Steve Barrow, Head of Standard Bank G10 Strategy.

So, if it is not the Fed or the terms of trade, why has the yen been so weak, and is this likely to change in 2023? Mr. Steve Barrow’s view is that the yen has weakened because Japanese overseas assets have deteriorated, whether those be loans or investments, and, as a result, banks and investors have adjusted their hedging in a way that lifts the dollar/yen. This relates to activity in the swaps market that we’ve been talking about recently. Japanese banks, for instance, fund their hefty overseas lending in many ways, including through the FX swaps market.

However, as these loans or investments sour, they are left in an overhedged position, which can be alleviated by dollar/yen spot purchases as well as other means. Data on the international claims of Japanese banks show a very strong uptrend for many years, particularly during the very low rate environment when domestic lending was both weak and lacking profitability.

>> How did Japan begin FX intervention?

Back in 2010, Japanese banks were behind other big international lenders like the US, UK, Germany, and France. But now Japan is way out in front and, importantly, was still forging ahead when the Fed underwent its 2015–18 tightening cycle (and hence why the dollar and yen did not rise despite higher US rates).

Fluctuations of JPY

The most recent data for this year shows that this has started to reverse as banks cut back, particularly with respect to China, and this could have created a demand for dollars, just as non-bank investors have probably been going through a similar situation as their investments were hit by the weakness in global bonds and stocks.

With this in mind, the outlook for 2023 very much depends on whether banks and investors suffer more difficulties with their international loans and investments. If 2023 is a better year for asset prices than 2022, as we suspect it will be, and if the Chinese economy recovers, as seems likely, it seems possible that the yen will strengthen through 2023, not weaken—and that’s irrespective of whether the Fed hikes further or Japan’s terms of trade deteriorate some more.