Although equity markets ended the week strongly, with the Dow gaining 1.75% and the S&P500 1.42%, it wasn’t clear how Barack Obama would respond to Republican efforts to attach policy conditions to a separate spending measure. The US president’s insistence that the debt ceiling be raised with no policy conditions attached has been a key bone of contention.
“USDJPY drivers are increasingly offshore and have become largely detached from the Japanese domestic story,” says Daniel Katzive, head of FX strategy North America with BNP Paribas in New York.
“It has become much more of a US trade and a risk trade over the past few weeks. Heading into what’s likely to be a tense week in Washington, USDJPY is vulnerable and the big short yen-position in the market could come under pressure as we approach the deadline.”
Market confidence about a potential deal at the end of last week evaporated on Tuesday, with USDJPY breaking below 97 to 96.63. However, the dollar gained 1.42% against the yen by Friday, suggesting currency traders believe that, with the opening of talks, the debt-ceiling end game is within reach.
“This behaviour is consistent with investors behaving as if a big risk event is out of the way and returning to the carry trade,” says Jane Foley, FX strategist at Rabobank in London.
Currency traders view the Japanese yen as a safe haven because of the underlying structure of the country’s economy, specifically the international surpluses caused by Japanese investors’ preference for offshore investments.
“During times of financial market stress, there is pressure on those assets to come home, and the resulting conversion back to the domestic currency drives yen appreciation,” says BNP’s Katzive.
With the Bank of Japan’s (BoJ) expansively accommodative monetary policy, Japanese investors continue to allocate to overseas markets, and have recently increased exposure to euro sovereign assets, suggesting that EURJPY might also come under pressure in event of continued uncertainty in the US.
“With Japan now significantly exposed to euro-denominated assets, this leaves the common currency vulnerable to repatriation,” says Calvin Tse, currency analyst at Morgan Stanley in Hong Kong. The euro gained 1.35% against the yen last week to close at 133.50.
For now, the pace of BoJ monetary easing appears stable. At its last policy meeting, the central bank offered no suggestion it was considering extending its accommodative policy and reiterated its view that the Japanese economy was recovering moderately with no need to expand stimulus.
“That said, even if the BoJ does not add to its hugely accommodative monetary settings, by the middle of next year the BoJ could be one of the only major central banks still following through with such a policy,” says Rabobank’s Foley.
Dealers say market participants have run short JPY positions consistently this year, first in anticipation of BoJ quantitative-easing measures and then on the expectation that the BoJ’s action would drive an increase in Japan investor demand for foreign securities.
So far, however, Japan investors have not responded to the BoJ’s policy action with aggressive outflows. “The big short JPY position that has been built up could be vulnerable if deterioration in the risk environment leads to a general exit from positions,” says Katzive.