Spiking U.S. bond yields and super-loose Japanese monetary policy are reviving the yen carry trade, which could spell more weakness in the currency after its biggest two-month drop in three years.
The yen was last in vogue as a cheap global funding vehicle for buying higher-yielding assets in 2005-2008, before the global financial crisis sent investors fleeing to the exits.
Now with a global economic recovery slowly picking up steam and Europe's debt crisis seemingly off the boil, traders are again looking to sell the low-interest rate yen to raise cash for forays into riskier and more rewarding assets.
With U.S.-Japan interest rate differentials narrow until mid-March and geopolitical risks troubling investors, many investors were sceptical the yen carry trade would make a comeback for the first time since the Lehman Brothers collapse.
But after a steady stream of encouraging news in recent months about the U.S. economy, traders expect the carry trend to make a comeback - and this time for good.
We are coming out of a very long period of severe risk aversion and the liquidity pumped in by the central banks is eventually being put to work. That's why the yen carry trade is not a bad place to be, Pierre Lequeux, head of currency management in London at Aviva Investors, which manages about $424 billion.
Look at what happened to all yen crosses from the beginning of the year. We have seen big gains because long-term investors have to move away from bonds and go for higher risk premia.
Rising U.S. short-term bond yields are making the dollar less attractive as a funding currency, leaving the yen as the main alternative. A surprise decision by the Bank of Japan in February which signalled a more aggressive policy easing stance has cemented those expectations.
Yen exchange rate: http://link.reuters.com/fav65s
Japan, U.S. T-bond yield: http://link.reuters.com/vyn66s
Yen, US/Japan bond spread: http://link.reuters.com/vyf36s
Japan GDP vs. yen: http://link.reuters.com/wyk96s
Current account, exports: http://link.reuters.com/cec56s
YEN BEARS WATCHING
To be sure, the interest rate gap between Japan and the U.S. is still too small now to directly spur investors to sell yen and buy U.S. bonds, but it is likely to widen further, keeping pressure on the yen. That in turn would make it more attractive for investors to sell it and buy higher-yielding currencies.
Indeed, some traders say this has already bolstered growth-linked currencies such as the New Zealand dollar against the yen. It has soared 11.3 percent on the yen this year, compared to its 5.1 percent rise on the dollar.
In an environment of abundant liquidity, and one in which Japanese investors have uncharacteristically stayed at home over the last two years, 2012 should prove to be a good year for the JPY-funded carry trade, said Chris Turner, head of currency strategy at ING in London.
We now see USD/JPY ending 2012 at 85 and rallying to 95 through 2013 as Fed tightening expectations build, he said, referring to views that the U.S. central bank may have to start unwinding its ultra-loose policy sooner than expected if America's economy continues to improve.
The yen was trading at around 82.60 to the U.S. dollar on Monday, after sliding more than 7 percent so far this year.
Jens Nordvig, global head of FX strategy at Nomura Securities, recommended bearish yen bets versus both the kiwi and the high-yielding Canadian dollar earlier in the year.
The latest shift in U.S. rates has put pressure on traditional funding currencies, and we have seen the yen weaken materially versus the dollar, he said.
Bearish bets against the yen placed by speculators more than doubled in the week to March 13 and exceeded those of yen bulls by roughly $6.4 billion - the largest net yen short bet since last April, Commodity Futures Trading Commission data showed.
This compares to some $19 billion worth of net yen shorts in late June 2007, when the yen shorts on CFTC hit an all-time high and the dollar peaked out, having risen roughly 20 yen over 2-1/2-years, partly on the popularity of the carry trade.
SOAKING UP BONDS
With an improvement in risk appetite across the globe, the two-year U.S. Treasury yield hit an eight-month peak of 0.414 percent in March. The fact that it is still only half of what it was a year ago shows it could go higher still.
By contrast, the yield on the two-year Japanese government bond has been stuck below 0.110 percent since the BOJ said on February 14 it will ease policy by spending an extra 10 trillion yen on JGBs as part of its asset-buying programme.
It also set a 1 percent inflation target, signalling a more decisive policy to end deflation.
The BOJ's steps have changed market sentiment and that's what helped the spread widen, said Sumino Kamei, senior currency analyst at the Bank of Tokyo-Mitsubishi UFJ in Tokyo.
The BOJ is effectively capping yields at the shorter end of the curve by soaking up bonds with up to two years left to maturity in the programme, in contrast with the Fed, which sells short-term paper as a part of its Operation Twist.
As a result, the U.S.-Japan two-year spread widened to as much as 28.9 basis points in March, compared with around 10 bps before the BOJ easing. That was the widest since July 2011.
The yen and the U.S.-Japan yield spread have historically enjoyed a close relationship, suggesting wider yield spreads will help push dollar/yen higher.
U.S. yields coming off historic lows may also prompt Japan institutional investors to unwind currency hedges on their hefty overseas bond holdings, boosting the dollar further.
On top of that, starting in April Tokyo life insurers could become more active in taking on forex exposure, especially since they have kept their currency hedge ratios high up to now, said a trader for a major Japanese bank in Singapore.
Barcalys Capital's strategist Masafumi Yamamoto estimates that if lifers were to cut hedge ratios by 10 percent, it could spur 1.25 trillion yen ($15.2 billion) worth of dollar buying.
More than rate differentials, it is further weakening in the (yen) spot price on Japan-related factors that could help the carry trade, said Yamamoto, who raised his three-month dollar target to 88 yen earlier this month.
(Additional reporting by Hideyuki Sano, Dominic Lau and Lisa Twaronite in TOKYO, Masayuki Kitano and Kevin Plumberg in SINGAPORE and Anirban Nag in LONDON; Editing by Kim Coghill)