USD/JPY crucial to broader bond market outlook - AmpGFX

Greg Gibbs, Director at Amplifying Global FX Capital, suggests that the steep fall in USD/JPY this year appears to have contributed to lower bond yields in Japan by undermining inflation and increasing expectations for additional policy easing. 

Key Quotes

“And the larger than anticipated fall in Japanese bond yields up to July appeared to spill over to deeper falls in global bond yields.  As such the appreciation of the JPY has been closely aligned with global bond yields this year.

A strong JPY has coincided with broad gains this year in riskier assets including equities, corporate bonds and emerging markets, despite the JPY historically been seen as a safe-haven asset.  This is because equities and riskier asset prices have risen in response to falling global government bonds yields rather than any enhanced confidence in economic growth.

Since 29-July, we have seen some divergence between JPY and bond yields.  Japanese yields have led a recovery in global yields, USD/JPY has been more erratic, but is overall still in a declining trend. We wonder now if the rise in bond yields will soon be joined and enhanced by a weaker JPY.

It is not particularly logical that higher yields in Japan should now weaken the JPY. However, if higher Japanese yields spill over the higher yields abroad, the market may not see higher yields in Japan as supportive for JPY.  Furthermore, we think the BoJ wants a twist in the curve, including lower short-term rates.  As such, we see a high probability of a deeper negative interest rate.  A deeper NIRP may weaken the JPY.  This would be very desirable from a Japanese policy perspective and it would support upward pressure on longer-term Japanese yields.

The BoJ would accept an overall bigger rise in bond yields (i.e. more genuine steepening without the twist) if it coincided with a weaker JPY, because the weaker JPY would help lift inflation expectations.

To the extent that global bonds may have become over-extended this year, the same may be true for the JPY.  As such, if the bond market corrects, the JPY may also correct and the two may seem correlated and their corrections reinforcing each other.

USD/JPY is yet to show much evidence of breaking its downtrend.  But it has been the longest period this year (since 23 June) that the USD/JPY has not made a new low, and it may be showing early signs of diverging from this trend.”