The US dollar/Japanese yen exchange rate has been moving up (weaker yen) and down (stronger yen) in line with US 10-year yields. The reason for this is that the Bank of Japan (BoJ) has outsourced its monetary policy to the Fed by promising to keep Japanese 10-year yields close to zero. When global yields rise, the Bank of Japan will buy more bonds to offset upward pressure on Japanese yields (loosening monetary policy and in turn weakening the yen). Conversely, it will buy fewer bonds when global yields fall (tightening monetary policy and in turn strengthening the yen).
Global yields are at historically low levels which explains why many investors expect yields to rise and keep duration positions low. Investors are broadly positioned to be short yen, often citing rising global yields as the main reason. We don't disagree with the duration view, but acknowledge that forward curves already price in a moderate rise in interest rates. We believe there are impediments for yields to rise much beyond forward levels, and still see value in particular bond markets, more so in Europe than elsewhere due to a lack of inflation in the Eurozone.
However, we do disagree with the commonly held negative yen view. Our base case still sees US yields rising, although gradually. This implies we may lose on a long yen position, as rising US yields could weaken the Japanese yen. But it's not all about what happens in your base case, and it's in the other scenarios where the Japanese yen can play an important role.
As with any good tail hedge you don’t want to lose too much if and when your base case materialises, a scenario that ought to get a high probability among your macro scenarios. We believe this to be the case, as our currency valuation metrics point to the yen being one of the cheaper developed currencies, so any mean reversion over time will benefit the yen. This will also limit any downside to the yen if yields were to rise.
Our alternative scenarios include, among others: a turn in global growth for the worse; a continued lack of inflation keeping liquidity in the market ample for longer; and a risk off environment. In these scenarios we anticipate the yen to rally hard.
Moreover, if growth in Japan disappoints, the market may start to question the sustainability of BoJ's monetary policy once again, arguing that yield curve control is just tapering in disguise. In the opposite case, where continued strong growth tightens the labour market and inflation surprises to the upside, the BoJ might start discussions on how to exit the framework.
All in all, the US dollar/Japanese yen exchange rate may go up the stairs amid slowly rising global yields, but down the elevator in many other alternative scenarios, including a small probability of a hawkish pivot by the Bank of Japan.