Yen Tumbles After The First BOJ Rate Hike In 17 Years; It Won't Last

It was one small step for the Bank of Japan, but a giant leap for the yen — albeit in the wrong direction, at least against the dollar. What gives?

There are several explanations for why the yen moved sharply... in the wrong direction after a historic BOJ move meant to signal tightening in order to bring prices lower, contain runaway inflation and, generally, boost the yen.

Let's start with the fundamental one: according to Bloomberg's Ven Ram, the real currency reaction will have to wait for Wednesday.

As the Bloomberg commentator notes, in line with news reports overnight, Governor Kazuo Ueda exited negative rates in a historic decision, but also scrapped yield curve control and ended its purchases of exchange-traded funds. The domestic markets, though, seem unenthused: nominal Japanese government bond yields fell alongside the currency, and even stocks couldn’t muster the excuse of a weaker currency to climb higher.

What gives?

The yen’s broad exchange rate is actually higher this month, though no one is getting excited. As trading interest goes in the currency markets, USD/JPY towers head and shoulders above other crosses, and there the headlines have been somber. The surge in front-end Treasury yields over the past week may not be as historic as the BOJ’s decision, but matters a whole lot more and then some for the dollar, which has made a meal of it.

The market’s deepest fear is that the Federal Reserve’s dot plot on Wednesday will take back one of the three interest rate cuts envisioned earlier. Even if the Fed were to do that, we know from Chair Jerome Powell’s recent statements that the central bank doesn’t want to keep rates as restrictive for a minute longer than it needs to, which means that the sell-off in Treasuries can’t continue for too long — fading some of the recent strength in the dollar.

Should the Fed’s dot plot indicate only two cuts this year, the yen will continue to be under a cloud. If the dot plot is intact and Powell strikes a dovish tone similar to his Congressional testimony, the yen will make a comeback. An immediate stop for USD/JPY will be around 144, levels that would be more aligned with its fundamentals.

What about the path beyond the short term?  Here, Ram's view differs slightly from that of Simon White, who earlier today made the following observation:

FX hedging will push the yen stronger, eliciting yet more hedging. It is this dynamic that drove USDJPY to rapidly drop 20% through the first half of 2016 (which can be seen in the rise in the hedge ratio around that time in the above chart). The 500-1 odds offered on USDJPY touching 130 by the end of Q2 – a level it was at little more than a year ago – sound very generous.

If inflation becomes ingrained, then eventually the yen will succumb to it, but in the shorter term, hedging flows as well as capital repatriation are likely to be the currency’s bigger driver. That also means an added fillip to unhedged foreign holders of Japanese assets.

Instead, Ram writes that with the "BOJ likely to move on rates at a pace that may be as exciting as watching paint dry, much of the impulse for the yen will come from dollar weakness. That moment will come when it becomes abundantly clear that Fed rate cuts, which have so far proved elusive, are imminent."

In either case, both agree: a much stronger yen is coming... and here a third Bloomberg commentator is in agreement, and this time from a purely tactical perspective: according to FX expert Vassilis Karamanis, for disappointed yen bulls, there’s "at least once again a clear tactical trade in sight", and explains:  

Given that the end of negative interest rates in Japan had been priced in by the FX market, the focus today is on forward guidance from the central bank. And by indicating that financial conditions will remain accommodative, policymakers are signaling that tightening in Japan will be nothing like the cycles adopted by other major central banks since 2022. The risk of a one-and-done hike is very much alive.

The yen had been under pressure against the dollar in the run-up to the policy decision, more than halving its gains since the market started positioning in late February for a rate increase. USD/JPY rose above 150 this morning, after hitting a 146.49 cycle low earlier this month. Now the year’s double-top at 150.85-89 is at risk.

This provides the opportunity to anyone looking to jump back on the yen-long bus to have a predefined, definitive stop loss. Those with a longer-term outlook, or deeper pockets, may look to sell rallies all the way up to the November high at 151.91, with the 2022 cycle high standing at 151.95. Chart watchers may be patient until the risk level of a daily DeMark Sell Countdown at 152.51 comes into play.

The problem for yen bulls is that price action into and after the BOJ decision suggests risk-reward isn’t what it used to be. If the greenback falls all the way to its recent lows, that would mean a 2:1 payout ratio for those short the pair; decent enough for spot traders. But options pricing signals caution.

It’s not that investors are rushing to own yen-downside exposure through options. One-week risk reversals are trading at 113 basis points in favor of the Japanese currency — a sharp contrast to a reading of 243 basis points a week ago, but one that matches the past year’s average. It’s not about directionality, but expectations of wider ranges ahead. That means USD/JPY could find mean-reversion support sooner than shorts are looking for, with the 55-DMA now standing at 148.24 and exhibiting an upward bias.

One-month implied volatility is close to 7% and heading for a sixth daily decline. If it drops another 40 basis points, hedging costs on the tenor will hit their lowest level in two years. At the same time, demand for low-delta options over the next three months is near the lowest level since 2021.

It’s not just about the BOJ’s patient stance. The latest move north in USD/JPY is also due to money-market bets on the Federal Reserve, with traders now looking for a total of 70 basis points of easing for the year, compared with 92 basis points on March 8. A rate cut by the Fed isn’t fully priced in until September, so there seems to be no imminent trigger for a big yen move in either direction.

Whether Fed communication this week prompts changes in rate expectations will be crucial for volatility, especially in a world where betting against wide ranges has become a profit-minting machine. But even if the market turns still less dovish on the Fed, the risk of intervention by Japanese officials in the spot market could cap expectations for a big, or abrupt, dollar rally.

All in all, Karamanis concludes that this historic but well-communicated BOJ decision won’t be what causes yen volatility to explode and "yen-funded carry trades still make sense" although the more the yen drops, the higher the imported inflation, the more the BOJ will have to hike to contain it, and so on. For now, Japanese investors may refrain from repatriating capital until the central bank becomes more hawkish, or the Fed gets closer to cutting rates. So while USDJPY may be all about trading familiar ranges for the foreseeable future, in the longer run it is going much lower.