A financial markets 'mystery.' The Japanese yen's slide is upending a once-reliable relationship

By Joseph Adinolfi

The yen has continued to weaken even as the spread between Japanese bonds and U.S. Treasurys has moved in Japan's favor recently.

The Japanese yen's latest round of weakness against the U.S. dollar has seen a normally reliable relationship between the bond market and currencies break down.

Typically, changes in exchange rates are governed by shifts in the spread between yields of their respective government bonds.

But since late April, the gap between 10-year Treasury yields BX:TMUBMUSD10Y and yields on corresponding Japanese Government Bonds BX:TMBMKJP-10Y has narrowed in Japan's favor, sliding from a year-to-date high of 3.817 percentage points on April 25 to 3.256 as of Wednesday, according to Dow Jones Market Data.

This should have been enough to arrest, or even reverse, the yen's depreciation against the U.S. dollar.

Instead, the Japanese currency has continued to weaken. One dollar traded above 162 yen (USDJPY) early Wednesday, touching its strongest level since December 1986, according to Dow Jones Market Data. But the buck later retreated as Treasury yields dropped following the release of the latest batch of economic data.

A prominent Wall Street economist said the yen's break with the U.S.-Japan yield differential was surprising.

"It is a real mystery. When Japanese rates rise relative to US rates you should see [dollar-yen] go down," Apollo's Torsten Slok told MarketWatch via email.

According to Slok's calculations, the Japanese yen should be trading closer to 140 against the U.S. dollar based on where yields are currently trading. That roughly corresponds to where the yen was at the beginning of this year. The yen has declined by about 12% since then, FactSet data show.

Ruben Gargallo Abargues, assistant economist at Capital Economics, this week also highlighted the dollar-yen pair's break with tradition.

Although Gargallo Abargues didn't speculate about what has been driving the currency lower over the past two months, he said the growing gap between the dollar-yen and the yield differential should help trigger a rebound in the Japanese currency once the Federal Reserve cuts interest rates, which it is expected to do before the end of 2024.

He added that speculators' increasingly lopsided bets against the yen should help to turbocharge the currency's eventual rebound. CFTC data showed speculators' positioning in futures were heavily short the Japanese currency, despite Japanese authorities' warnings about a potential intervention.

Japan spent a record $62 billion to prop up the yen in late April and early May, according to data released by the Ministry of Finance in late May. This previous intervention came as the dollar-yen currency pair neared the 160 threshold, which it recently crossed.

Others think the yen's latest leg lower still makes sense despite the move in yields. Marc Chandler, chief market strategist at Bannockburn Global Forex, said the yen's ongoing slide reflects traders' growing doubts that the Bank of Japan will begin the process of trimming its trove of government bonds later this summer.

The BoJ raised interest rates for the first time since 2007 earlier this year, but announced last month that it would delay plans to start trimming its balance sheet.

Chandler also pointed out that the currency pair has lately appeared more sensitive to moves in U.S. Treasury yields, which have risen in recent weeks.

Also, the yen's weakness appears to have benefited Japanese stocks, strategists said.

The Nikkei 225 JP:NIK recorded its fourth-highest close ever on Wednesday, while Japan's broader TOPIX Index JP:180460 finished within striking distance of a record high, according to FactSet data. On Thursday, the Nikkei logged a new record close of 40,913.65.

-Joseph Adinolfi

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07-04-24 0819ET

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