What Next For The Yen?In Karate, offense is the best form of defence. The BoJ knows it. Japan faces a raft of economic headwinds which shows up in Yen’s performance.
The BoJ intervened strongly last year to support the currency when it skirted around current levels. Yen is hovering at those levels again. BoJ is anticipated to act. Such interventions typically mark the bottom.
This paper explores recent economic data to analyse the potential for monetary policy changes by BOJ.
JAPANESE MACROECONOMIC CONDITIONS HAMPER YEN FROM STRENGTHENING
Starting September, the Yen has trended lower relative to the USD among currency majors.
The Yen has weakened the most. As described previously , BoJ’s aims to kickstart the economy onto a high growth trajectory to exit decades of painful deflation.
Recent macroeconomic data indicates weakness. This reaffirms the need for continued loose monetary policy. However, a frail Yen poses a different type of challenge for the BoJ with higher import costs for fresh food and fuel.
This leaves the BoJ in a predicament between loose monetary policy and intervention to support the Yen. What does recent inflation, GDP, and wage data point to?
Inflation
Inflation declined M-o-M in September. CPI cooled to 2.8% falling below 3% for the first time in a year. Importantly, Japan’s producer prices are now below 2% in a sign that inflation might have peaked.
Consumer prices will fail to prevail above 4% for long with input prices moderating. The BoJ expects inflation to persist until March next year at current levels and to cool towards target rates in the following 12 months.
GDP Growth
The Japanese economy shrank 2.1% YoY in Q3. This is far below expectations of 0.6% decline and a sharp slowdown from +4.5% growth in Q2. Slow economic growth makes economic stimulus essential to sustain it.
Wages
Nominal wage growth continues to decline. Real wages are even more concerning. Wages have declined for the last 18 months when adjusted for inflation.
Next Shunto negotiations are set to complete by mid-Jan 2024 with outcome remaining uncertain. The BoJ highlighted that wage uncertainties and price-setting behaviour pose upside risk to prices.
Meanwhile, high inflation will keep impacting real wages, affecting people's ability to spend.
THE BANK OF JAPAN IS STUCK BETWEEN A ROCK AND A HARD PLACE
At the October monetary policy meeting, the BoJ announced changes to the bond yield cap. The Yield Curve Control (YCC) policy and range were kept unchanged.
However, a small modification was made to change the 1% JGB yield cap from a rigid one to a loose reference. These changes hint at BoJ setting itself up for the eventual roll-back of the YCC policy altogether.
Next BoJ policy meeting is set for December 19th. The BoJ will likely maintain stimulus and hold rates low amid feeble consumer & business spending.
The policy change will be through YCC dismantling, impacting the JGB market. It will require careful planning and deft timing.
Meanwhile, the BoJ may intervene to stem continued Yen weakness. The officials have expressed this sentiment over the last two weeks via warnings for participants shorting the Yen over the past two weeks.
Japan’s Ministry of Finance (MoF) intervened three times last year, injecting USD 68 billion to support the Yen when it was trading near 150/USD. These interventions, unannounced, led to sharp and unexpected currency moves.
Unlike previous exchange rate-based interventions, the BoJ’s current predicament revolves around volatility and public perception.
Reuters reports that if Japan aims to prevent yen appreciation, the MoF will issue short-term bills to raise Yen, which is then sold in the market to weaken the currency. Alternatively, to curb Yen depreciation, authorities will tap into Japan's FX reserves, exchanging dollars for the Yen.
In recent weeks, Japanese authorities have issued warnings and expressed readiness to intervene as the Yen continues to weaken, despite a moderating USD.
Masato Kanda, Japan's top currency official, emphasized the urgency of their judgments and the potential for intervention, resonating with rhetorics used a year ago.
MIXED SIGNALS FROM CURRENCY DERIVATIVES MARKETS
Although asset managers are not positioned as net short as they were in late-September, they increased their net short positioning (weakening Yen) last Tuesday. Similarly, leveraged funds also increased net short positioning sharply last week.
Options markets contrarily signal strength in the Yen. P/C ratio for CME Japanese Yen Options (JPU) is 0.42 implying two puts for every five calls. JPUs are quoted with the Yen as the base currency so call options express a view of the Yen strengthening.
Moreover, bullish bets have increased heavily over the past week. Specifically, nearest monthly and weekly contracts (JPZ3 and WJ4X3) show Yen strengthening in the near term. Bullish bets in December options outnumber bearish bets by three times.
Although put open interest (OI) is concentrated near current levels with the highest OI at 0.0066 (151 in USD/JPY), call OI is more spread across with a large OI at strike of 0.0069 (145 in USD/JPY) which has ballooned over the last week. This signals that options market expects Yen strengthening by next month.
Finally, implied volatility on JPU is near its lowest level since March 2022.
Source: CME CVOL
Options skew on JPU is close to one, indicating that premiums on calls and puts are equally priced. Convexity remains elevated signalling investor interest in OTM options suggesting likelihood of sharp moves ahead.
HYPOTHETICAL TRADE SETUP
Given 12-month low implied volatility, a position in JPU can yield cost-effective protection against sharp Yen moves.
Alternatively, with the anticipated stability in Japanese interest rates, a short futures position in CME Japanese Yen futures, as previously discussed in a paper , is a viable approach to capitalizing on Yen's expected weakening. We can tap into JPU to safeguard this position against unforeseen risks of yen strengthening from BoJ intervention.
Furthermore, CME offers weekly options for Japanese Yen futures, expiring from Monday through Friday of the week. This enables investors to attain short-term exposure on a more focused scale, accompanied by lower premiums compared to monthly options.
A long call option position in JPUZ3 (expiring on December 8) would benefit from a BoJ intervention.
The trade setup consists of an entry at a strike of 0.0068 (JPY 147.0588) in JPUZ3 call options. These options are at a delta of 25 and expire in 30 days providing a good trade-off between low premium and adequate exposure to the underlying.
As of settlement on November 17th, premium for these options stood at USD 245 at an implied volatility of 8.26%.
Source: CME Options Calculator
The position breaks even at 0.00682 (JPY 146.6275) and turns profitable when (a) underlying futures price increases above strike price, and/or (b) implied volatility increases.
Source: CME QuikStrike
MARKET DATA
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