How You Can Gain Exposure To Weaker JPY & Stronger Nikkei

On Friday, Japan intervened in the currency market for the second month in a row, buying yen in an attempt to slow its rapid decline. This is an unusual move for Japan: the last time it intervened in the foreign-exchange market was after the Fukushima nuclear disaster in 2011 when policymakers sold yen to contain its rapid climb. So, given the unusual nature of this kind of move, it’s worth considering why Japan’s doing this now and what the opportunity is.

So, What’s Up With Yen?

The yen has been struggling lately, having fallen to 32-year lows. It’s been the weakest of the major currencies this year, declining 29% against the strong US dollar and 8% against the floundering British pound.

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The yen is struggling because interest rates are rising in other developed countries. This makes these currencies more attractive to foreign investors and savers. In Japan, however, rates have stayed near zero.

The yield spread between the two-year US Treasury and Japan’s two-year government bond is 4.47%. This means that if you hold the US bond for a year, you’ll earn 4.47% more than you would by holding the Japanese bond.

Now, look at how closely “dollar-yen”, the USD/JPY currency trading pair (left-hand axis), is tracking the yield spread. As the yield spread widens, so does the dollar’s edge over the yen.

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What Could Boos Yen?

The Bank of Japan (BoJ) has an inflation target of 2% per year. However, in September, Japan’s CPI reached a new eight-year high of 3%. The BoJ believes that the overshoot is temporary and that wages have not increased accordingly. As a result, the BoJ has kept its interest rates low.

The lifting of Covid restrictions and the reopening of Japan’s borders may lead to an influx of tourists, which could spur a hiring boom – a tough prospect in Japan’s already tight labor market (the unemployment rate is just 2.5%). To attract workers, employers may have to offer more generous pay.

The BOJ’s yield curve control policy is designed to keep interest rates low. The 10-year bond yield is currently set at around zero, with an allowable band of +/- 0.25%. However, there is speculation that this policy could change when a new BoJ governor takes office in April 2023. If the policy did change, it could have an impact on the strength of the yen.

If the Federal Reserve (the Fed) were to halt its aggressive rate hikes, and even begin to lower interest rates, the yen could gain against the greenback as the yield spread shrinks. However, this is not expected to happen soon.

Should We See More BOJ Interventions Any Time Soon?

In Japan, the BoJ decides monetary policy (e.g. interest rates), but the Ministry of Finance (MoF) decides when it’s time for the BoJ to intervene in the foreign exchange market. A range of factors influences the MoF’s decision, as a weak currency has both winners and losers. 

Japanese companies with huge overseas operations may benefit from the weak yen, as it increases the value of the money they make abroad. But households and domestically focused businesses may be hurt by the higher cost of imported food and energy.

The Ministry of Finance has publicly stated that it is concerned about the speed of the yen’s decline, but not about its overall level.

Approximately $19 billion was spent by policymakers on the yen in September’s market intervention, with a potential of up to $37 billion being spent in the past week.

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So What Are The Bets Here?

If you don’t think that Japan will change its stance on interest rates, it can be a wise move to buy USD and Sell Yen (go short on USD/JPY) short term. 

You should, however, keep in mind these two events that could possibly ruin this speculation coming into 2023: the change of the Bank of Japan governor; and the possible decline in US interest rates. 

Another bet could be a bet on Japan Nikkei 225 index which is seeing only a 6% drop (when priced in yen), this is mostly due to Japanese companies being export-oriented and benefiting from a cheaper yen. Despite the lower than other major indexes drops, Japan’s market valuation still boasts good numbers, an average of 12x price-to-earnings and 1.1x price-to-book ratio. 

Hence, going long on the Nikkei 225 might not be such a bad idea coming into 2023. A more intricate play could be betting on iShares MSCI Japan ETF (EWJ) and Franklin FTSE Japan ETF (FLJP), which both will provide you with exposure to large and mid-size Japanese firms.

Don’t forget that these don’t offer a currency hedge, though, as your returns may plummet due to a weaker Japanese yen. For instance, the Japanese Nikkei 225 fell a whopping 28% in US dollar terms. To stay protected against the weaker Japanese yen, you can try betting on WisdomTree Japan Hedged ETF (DXJ). 

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Disclaimer: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. On average around 80% of retail investor accounts loose money when trading with high ...

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