JPY: Why the yen’s at a crossroads



Bearish flattening of the US Treasury curve helping USD/JPY

Despite all the concerns of an escalating trade war, the world’s favourite safe haven currency – the Japanese Yen (JPY) – is drifting towards its lowest levels of the year against the US dollar (USD).

Typically a flattening in the US Treasury curve has proved bullish for USD/JPY. Here, the typically held view is that the relative rise in short-end US rates relative to the long end makes dollar hedging costs disproportionately expensive. Japanese investors, therefore, reduce their rolling three-month dollar hedges, leading to dollar demand. Assuming US equities do not crash this summer, the current bias is for US yields to push higher this summer as US price pressures stay firm and the balance of risks favour USD/JPY towards 114/115 at this stage.

Trade war escalation extends into the US Treasury market?

However, those positioning for higher USD/JPY will have to be nimble. China could start considering alternative routes to retaliate against US. One of these qualitative threats from Chinese authorities is that of diversifying away from its large (US$1 trillion+) worth of US Treasury holdings (probably towards European debt markets). Clearly, it would take much provocation for the Chinese to undertake this act of economic self-harm – since the result would be to devalue both the asset and the currency which comprise the largest share of its foreign exchange reserves. Any early signs of the Chinese losing interest in US Treasuries could emerge from their participation at US Treasury auctions. Typically foreign central banks hold US Treasuries with a maturity of five years or less. Were the indirect bid (a key metric of foreign participation at US Treasury auctions) to fall dramatically at the next five-year auction (July 25th), the market could take fright.



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