Financial Services Association, May 28 (Editor: Xiaoxiang) 155, 156, 157 — For traders in the foreign exchange market, watching the yen fall step by step over the past week and start falling back towards the 160 mark, the extremely familiar depreciation scene of the yen at the end of last month seems to be unfolding again...

On Thursday, the US dollar hit a high of 157.19 against the yen, breaking the highest level in nearly four weeks. It is not far from the 34-year high of 160.20 set by the April decline. However, this scene also undoubtedly indicates that although the Japanese authorities suspected direct entry directly interfered with the yen exchange rate twice at the end of last month and the beginning of this month, the “efficacy” of these two interventions may have come to an end:

To prevent the yen from falling further in a short period of time, the Japanese authorities will either step back in blood and intervene (apparently still not saving the root), or they can only find another way.

Of course, according to many foreign exchange traders, the Japanese authorities actually don't have many “new tricks” available today; even the Bank of Japan's interest rate hike this summer may not have saved the yen. They said that as long as there is still huge demand for arbitrage trading, which is currently one of the most profitable betting strategies in the foreign exchange market, then the insignificant increase in Japanese interest rates expected by the market will not help save the currently troubled Japanese yen.

Arbitrage trading is popular in the foreign exchange market

In fact, over the past few years, the yen has been one of the most popular macro assets, and is often sold off as a financing currency for so-called arbitrage transactions. The logic of this strategy is simple: due to the Bank of Japan's long-term zero interest rate or even negative interest rate policy, people can borrow yen at almost zero cost and then use these yen to buy dollar assets to earn 5% or more. The weakening yen and the strengthening of the US dollar together increased the appeal of such arbitrage transactions, so that the total return last year could rise to 18%.

A set of intuitive comparisons can clearly show the current appeal of Japanese yen arbitrage trading:

Even though Japan's 10-year Treasury yield hit a 12-year high last Friday — breaking through the 1% mark, there is still a huge gap between it and the US Treasury yield for the same period: the 10-year US Treasury yield is currently around 4.64%, and the spread between the two sides is still over 360 basis points.

And this is just a comparison between long-term bond yields. If you invest in short-term treasury bonds, the gap will obviously be even greater. Currently, since the inversion of the entire US bond yield curve is still obvious, the yield on 1-year US bonds and all US bonds with shorter terms is still above 5%.

Antony Foster, head of G10 spot trading at Nomura International in London, said, “People are very fascinated by arbitrage trading. Even if the Bank of Japan actually raises interest rates in June — we expect to raise interest rates slightly and then raise interest rates again later this year, this spread will still exist, so the market will be very reluctant to go long on yen.”

Since this year, the exchange rate of the yen against the US dollar has fallen by about 10%, making it the biggest decline among G10 currencies. The reason for the depreciation of the yen was due to a large number of investors selling the yen and choosing a currency with a higher yield. Some market participants have warned that as long as these arbitrage strategies continue to be popular, the yen could fall back to the 34-year low hit last month.

How are the Japanese authorities dealing with the Japanese yen's life-or-death situation?

It is worth mentioning that the Japanese authorities seem to have recently been desperate to curb the apparently excessive depreciation of the yen, and this may once again trigger a tense confrontation with the yen bears.

It was under Japanese lobbying that G7 finance ministers reaffirmed their commitment in a communiqué issued after last Saturday's meeting — to be wary of excessive fluctuations in foreign exchange rates. Prior to the G7 finance ministers statement, Japan's top official responsible for foreign exchange affairs and Deputy Minister of Finance Masato Kanda discussed the possibility of Japan's intervention in the foreign exchange market again on Friday. He told reporters that the Japanese government is ready to take action “at any time” to deal with excessive fluctuations in the yen.

Masato Kanda stated, “If excessive fluctuations adversely affect the economy occur, we need to act, and it is reasonable to do so.”

Apart from potential further direct intervention, the Bank of Japan does not rule out the possibility of further interest rate hikes in this summer's interest rate decision. The interest rate swap market has now reflected that the Bank of Japan will raise interest rates by another 27 basis points this year. The possibility of raising interest rates as early as July was as high as 90%.

However, many industry insiders also said that since traders have taken interest rate hikes into account, any tough “hawkish” signal sent by the Bank of Japan next month may not be enough to stop the yen from weakening further.

Mingze Wu, a Singapore-based currency trader at Stonex Financial Pte Ltd., said that any (hawkish) move by the Bank of Japan may be too late in the face of the current market trend, and demand for arbitrage trading is conducive to shorting the yen. The risk of the dollar against the yen tends to rise, returning to the level before the Bank of Japan intervened.”

Some investors are now also closely watching whether Bank of Japan Governor Ueda Kazuo will try to stop the yen exchange rate from falling continuously next month. Since the market believes that it is unlikely that the Bank of Japan will choose to raise interest rates in June, arbitrage traders will pay close attention to whether the Bank of Japan will adjust other policy tools.

Jane Foley, head of foreign exchange strategy at Rabobank in London, said, “Kazuo Ueda may choose the wording very carefully to avoid appearing dovish compared to market expectations. He and Japan's Ministry of Finance probably hope that no further intervention is needed, but as long as Japan's economic data weakens and US data continues to signal recovery, this cannot be guaranteed.”

Editor/Somer