The latest bout of weakness in the yen against the dollar has caused a breakdown in the usually reliable relationship between bond and foreign exchange markets.

Typically, changes in exchange rates are governed by changes in the yield spreads of their respective government bonds.

The gap between 10-year U.S. Treasury yields and their Japanese counterparts has narrowed since late April, sliding from a year-high of 3.817 percentage points on April 25 to 3.256 percentage points on Wednesday, according to Dow Jones Market Data. That should be enough to halt or even reverse the yen’s depreciation against the dollar.

Instead, the yen continued to weaken. The yen hit its highest level against the dollar since December 1986 on Wednesday, according to Dow Jones Market Data, even as the dollar retreated as U.S. Treasury yields fell following the release of the latest batch of economic data.

The interest rate differential between the U.S. and Japan has narrowed (red line), but the yen is still depreciating (blue line)

A prominent Wall Street economist said the breakdown in the yen’s relationship with the U.S.-Japan interest rate differential was surprising.

“It’s a real puzzle,” said Torsten Slok, chief economist at Apollo Asset Management. “When Japanese yields rise relative to U.S. yields, we should see the yen rise against the dollar.”

Based on current yield levels, the yen should be trading closer to 140 per dollar, according to Slok’s calculations. That’s roughly where it was at the start of the year. Since then, the yen has fallen about 12%, according to FactSet data.

Slok's model shows that based on current yield levels, the yen should be close to 140 per dollar.

Ruben Gargallo Abargues, assistant economist at Capital Economics, also highlighted this week that the yen is breaking out of tradition against the dollar.

While Gargallo-Abagnale stopped short of speculating on what has driven the yen lower over the past two months, he said the widening gap between the dollar and yen and a narrowing yield differential should help spark a rebound once the Federal Reserve cuts rates, which he expects to happen by the end of 2024.

He added that speculators’ increasingly unbalanced bets on the yen should help fuel an eventual rebound in the currency. CFTC data showed speculators were heavily short yen futures despite warnings from Japanese authorities of possible intervention.

Japan spent a record $62 billion to support the yen in late April and early May, according to data released by the Ministry of Finance at the end of May. Previous interventions were carried out when the yen was close to 160 against the dollar, but the currency pair has recently broken through this mark and the authorities have not yet intervened.

Others believe the yen’s latest slide makes sense despite the yield swings. Marc Chandler, chief market strategist at Bannockburn Global Forex, said the yen’s continued decline reflects traders’ growing doubts about whether the Bank of Japan will begin reducing its government bond reserves later this summer.

The Bank of Japan raised interest rates earlier this year for the first time since 2007 but announced last month it would delay plans to reduce its balance sheet.

Chandler also noted that the pair recently appears to be more sensitive to moves in U.S. Treasury yields, which have risen in recent weeks.

In addition, strategists said a weak yen also appeared to be a boon for Japanese stocks. The Topix blew past bubble-era highs to close at a record high on Thursday, while the Nikkei 225 also hit a new high.

The article is forwarded from: Jinshi Data