[LFX]

USDJPY is expected to remain under selling pressure as Japanese investors will either reduce their holdings of non currency hedged US Treasuries or increase the
currency hedge on existing positions. The steep US yield curve in combination with rising US inflation expectations point in the same direction. Low US interest rates have reduced USD hedging costs. Latest MoF data show that Japan bought USD125bln of foreign bond of which the vast amount were USD denominated. Japan’s bond holdings abroad have exceeded USD2trn making debt the most sizeable asset class held abroad. From a Japanese perspective a deflationary US scenario would be less damaging compared to a stagflationary or inflationary outcome as rising inflation undermines the value of a bond portfolio.

The subsequent increase of bond-yields has lent USDJPY support, this support is regarded only as temporary. First, bond yields are unlikely to rise beyond 4% for 10-year Treasuries given weak overall demand for credit and the weakening impact bond yields will have on the housing market. Secondly, rising nominal yields have seen real yields declining, simultaneously suggesting that rising yields are not based on the expectation of a durable rebound of economic activity. The decline of real US bond yields explains why the positive correlation between nominal US bond yields and USDJPY has eased.

However, it is not only US debt that is running into trouble. In Japan the sovereign 5-year CDS has rallied from 37bps traded mid-September to 76 bps per
yesterday as investors have priced in a higher risk of a Japanese sovereign default. This compares to the US 5- year CDS having remained stable at 23bps. The impact of credit risk on currencies depends on the net foreign asset position of countries. Japan runs a substantial net asset position abroad and foreign holdings in JGB’s are minor and currency hedged. In fact, JPY hedging incomes (due to low JPY interest rates) used to be the main motivation of foreign accounts to hold JGBs. Should foreign accounts liquidate their Japanese bond holdings it would simultaneously eliminate their JPY hedges, hence, this operation would be currency neutral. Meanwhile, Japan’s private sector sill runs large savings which are looking for investment. Rising Japanese sovereign credit risks will increase domestic yield levels, which could even lead to a reverse effect where rising credit risks increases local bond yields, motivating more Japanese investors to keep funds within domestic bonds. In past cycles the JPY always rallied when CDS spreads where rising, but this had more to do with the CDS acting as a barometer for global risk appetite / risk assessment. A break of USDJPY 89.70 opens downside potential to 85.00.