The easing of global financial pressure has increased the appeal of Japanese yen financing arbitrage transactions and increased the risk of yen depreciation. This will also increase the possibility that the Japanese authorities will interfere in the foreign exchange market.

Bank of America's Global Financial Stress Indicator (Global Financial Stress Indicator) fell to a four-year low last week, indicating that investors' interest in high-yield, high-risk assets is high. The yen is the only remaining currency in the world with a negative interest rate. The yen fell against the US dollar for the eighth consecutive week on Friday. This is the longest losing streak since October 2022. The Bank of Japan's policy tightening will be slower than what traders expected, thus limiting the room for the yen to rebound, especially against the US dollar, because the yield on US Treasury bonds is the highest in the G10 market. Economic data from major economies unexpectedly showed an upward trend over the past few weeks, prompting US and European policymakers to warn against being too sure that interest rate cuts are imminent.

The yen fell as market pressure eased

Makoto Noji, chief foreign exchange and foreign bond strategist at Sumitomo Mitsui Banking Corporation Nikko Securities in Tokyo, wrote in a research report, “Amid optimism in the global market, bets on Japanese yen financing arbitrage transactions may be increasing. Even if the Bank of Japan raises interest rates slightly, the real policy interest rate will remain negative for a longer period of time.”

The Bank of Japan's short-term policy interest rate is more than 2 percentage points lower than Japan's core inflation rate. The yen has fallen below the level of Japan's Ministry of Finance when it entered the market in September 2022. Tokyo strategists expect that if the yen depreciates to around 152 yen per dollar, the authorities will remain on high alert. The exchange rate on Monday was around 150. Alex Loo, a Singapore-based foreign exchange and macro strategist at TD Securities, said the market “can be expected to increase verbal warnings from the authorities about speculative yen movements. The USD/JPY exchange rate is likely to be affected by the US bond market, which may push the pair past last year's high.”

Speculators are betting that the yen will depreciate further. Net short positions in yen held by leveraged funds and asset managers climbed to their highest level since mid-2022 last week, according to the US Commodity Futures Trading Commission (CFTC). Commonwealth Bank of Australia foreign exchange strategist Carol Kong said, “Given that the US economy is still resilient, I think there is room for further growth of the dollar against the yen in the near future.”

Net short in yen

However, traders hoping to profit from the large fluctuation of the dollar against the yen may suddenly wake up, as the yen may be caught between rising chances of intervention and US interest rate bets. The strategist said that the one-month implied volatility of the dollar against the yen could fall to its lowest level since March 2022. What is driving the decline in volatility is the pair's narrowing daily trading range, which is due to resistance from both sides limiting the trend.

“The dollar seems to be in a dilemma against the yen. On the one hand, Japan's Ministry of Finance is threatening to intervene, and on the other hand, the Bank of Japan is reducing the possibility of interest rate hikes, which has provided impetus for the decline in the exchange rate,” said David Forrester, senior foreign exchange strategist at Credit Agricole CIB (Credit Agricole CIB).

The biggest daily fluctuation of USD/JPY last week was only 0.75 yen, compared to over 2 yen at the beginning of January. Since the yen is likely to fall to around 150, options traders will pay close attention to Japan's inflation data released on February 27 to see if it can be a catalyst for the yen to break through narrow fluctuations. Bank of Japan Governor Ueda Kazuo hinted last week that he is still confident about the prospects of achieving stable inflation. Some analysts say this is an indicator of policy changes.

If the yen does not break through the range, it seems likely that the USD/JPY implied volatility will continue to decline. Ruchir Sharma, global head of foreign exchange options trading at Nomura International, said, “Our basic forecast is that the monthly volatility rate will fall to the 6.25-6.75 range in the next few weeks.” He said that this is not only due to the strength to maintain the currency pair's fluctuation in the range, but also that trading factors may play a role. Sharma said that some clients have established options positions, which will benefit from a slow rise in the USD/JPY exchange rate over the next few weeks.