The Strategist

Dollar-Yen Dynamics: the Carry Problem

The dollar-yen exchange rate is primarily influenced by the cost-of-carry issue, which hinges on the key policy rate decisions of the Fed and the Bank of Japan (BOJ). If the Fed starts to ease or the BOJ normalises interest rates, diminishing yield differentials would prompt a reversal in the USD/JPY pair. Potential interventions by the BOJ might not substantially alter the trend. While extended positioning and valuations point to a potential pullback for the USD/JPY exchange rate, timing such a move is challenging as policy rate decisions by the Fed and BOJ remain uncertain. 

Sebastian Petric, LGT Senior FX Strategist
Temps de lecture
10 minutes
The Strategist USD YEN
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The primary driver of the dollar-yen exchange rate remains the unresolved cost-of-carry condition, which will persist until there is a change in the monetary policy outlook from the Fed and/or the BOJ. While there is always the risk of intervention by the BOJ via direct JPY purchases, such actions alone are unlikely to significantly alter the trend in the short term.

Impact of carry trade and monetary policy realities

The dollar-yen has been driven by the carry trade, and until the Fed begins an easing cycle or the BOJ more aggressively pursues rate normalisation, this dynamic will likely continue. There is a possibility that this could change if the Fed cuts rates within the coming months or if the BOJ hikes rates soon (e.g., at its next policy meeting at the end of July). Despite this, the current momentum behind USD/JPY makes it difficult to time a reversal.

Difficulties in predicting trend reversals

Holding a bullish view on dollar-yen is challenging as extensive positioning, valuation, and historical levels suggest a pullback could be imminent. However, without a clear trigger from either the Fed or BOJ, it is tricky to time such a pullback as policy rate decisions in both countries remain unclear. The expected target of USD/JPY 150 within six months is being challenged, and consolidation within 160 and 165 may occur until a monetary policy trigger emerges.

Possibilities and risks of foreign exchange interventions

The risk of BOJ FX intervention increases with continued yen weakness, but this is unlikely to sustainably change the overall trend. Unilateral intervention might slow USD/JPY appreciation, but it would be more effective if the US dollar had already started to decline on a global basis. Coordinated FX intervention by G-7 nations seems unlikely in the current context. 

Positioning remained broadly underweight against the Yen. If sentiment towards the Yen improves and investors unwind their positions, this extended positioning could lead to a bullish Yen price action. 

One important consideration is that real yields in Japan continue to be significantly negative. For a reversal in the USD/JPY exchange rate to be sustainable, it is crucial that there is an increase in real yields, and not only in nominal yields. Once real interest rates in Japan begin to rise significantly, the narrowing gap in the yield differential should potentially trigger a sharp reversal in the USD/JPY exchange rate.

In conclusion, the USD/JPY exchange rate is primarily influenced by the monetary policies of the Fed and the BOJ, creating a cost-of-carry problem. Current dynamics are expected to continue until the Fed eases or the BOJ normalises interest rates. Interventions by the BOJ may not have a significant impact on the trend. While positioning and valuations suggest a potential pullback for the dollar-yen, the timing is challenging due to the carry cost. However, a significant increase in real interest rates in Japan could trigger a sudden reversal in the USD/JPY exchange rate.

Overall, the various factors suggest a strategy of selling USD and buying JPY, anticipating downside for USD/JPY. The changing cost-of-carry issue and extensive market positioning point to the potential for Yen strength, if there are changes in monetary policies or market sentiment.

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