At the end of January, the Bank of Japan (BOJ) announced the introduction of negative interest rates. It was a surprise move. However, it was consistent with many other measures taken by the BOJ and the Japanese government to help stamp out deflationary pressures and ignite stronger growth.
The initial reaction in the financial market was that the JPY (Japanese yen) weakened, the Nikkei got a boost, and the Japanese Government Bond (JGB) yields plunged into negative territories. The problem for the BOJ was that the initial reaction was short-lived and other market factors caused the JPY to suddenly appreciate. In fact, today, it has strengthened 7.3% stronger against the U.S. dollar from the beginning of this year.
Why did the JPY strengthen when the BOJ took pro-active monetary easing measures?
- First, keep in mind the JPY had weakened substantially over the past three years. The underlying transactions included huge amounts of ‘carry-trades’ accumulated over the years, where (Japanese) investors would sell JPY and buy foreign securities such as U.S. Treasuries or any other higher-yielding currencies. They did not hedge the FX risk, because they had a view that the JPY would keep on falling. This risk exposure was too big; a result of three years’ accumulated short JPY positions.
- The rapid 8% increase in the JPY in the 10 days after the announcement suggests that the need to quickly cover those carry-trade positions snowballed because too much risk was exposed. This is achieved with financial contracts such as FX forwards and does not necessarily accompany the physical selling of the underlying USD securities in exchange for JPY assets (besides, what is there to buy?) The JPY buying pressure was quick and sharp.
- The BOJ didn’t intervene to sell the JPY since this price action should not necessarily be deemed unhealthy if investors are putting on hedges to reduce their risk exposures.
Although some believe that the BOJ’s move backfired, I believe that the JPY will eventually start weakening again as long as both the BOJ and the Fed are consistent in their policies. Again this week, the BOJ has reassured the markets that it will continue its policy with quantitative easing and negative interest rates until it achieves 2% inflation. The U.S., although slowing, is still on the rate-rising trajectory. Currently the market has settled, and fundamentally, there should be very little incentive to buy more JPY at this point, especially with negative interest rates. Would YOU want to buy JPY and put them in a safe?
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