The yen's fall has stoked bets that the Bank of Japan will turn hawkish, with investors shorting bonds, buying Japanese bank shares and positioning themselves for a rate hike as early as next month.

Markets are watching this closely because the last rate hike by the Bank of Japan (3.5 months ago and against the global trend of rate cuts) was one of the triggers for sharp fluctuations in the yen and the rapid unwinding of yen funding positions around the world.

With the yen at 154 per dollar, close to levels that previously triggered intervention and subsequent rate hikes, investors have been cautious this time around in accumulating positions, especially in bank stocks, which typically benefit from higher interest rates.

“It seems like the market is paying more attention and sensitivity to the Bank of Japan,” said Shinji Ogawa, co-head of Japan cash equity sales at JPMorgan Chase & Co. in Tokyo. “That’s expressed through various asset classes, whether it’s outright overnight index swaps ... (or) financials, where share price movements are clearly very sharp.”

Some hedge funds are also betting on higher Japanese government bond yields, traders said. The probability of a 25 basis point rate hike by the Bank of Japan in December has risen from negligible to about 54% since late October.

"Fast money is again focusing on the short end of the yield curve, with hedge funds accumulating a small number of short positions in recent weeks," said Keita Matsumoto, head of financial institutions sales and solutions at Citigroup Global Markets Japan.

Japanese bank stocks have risen about 13% in the two weeks since the U.S. election, while the broader market has been largely flat, with exporters, especially in cyclical sectors such as industrials and machinery, being another group of outperformers.

“We are focused on Japanese mid-cap stocks and Japanese banks as they will benefit from wage inflation and higher interest rates, respectively,” said George Efstathopoulos, manager of Fidelity International’s Global Multi-Asset Fund, which manages $102 million. “We have also recently become more positive on the broader Japanese large-cap stocks as a weaker yen should translate into better earnings prospects as global growth reaccelerates.”

Yen Story

The yen is a major factor in the performance of Japan's economy and stock market and can influence monetary policy through import costs (driving inflation).

Bank of Japan Governor Kazuo Ueda made only passing mention of the yen in his closely watched policy speech on Monday. The yen has depreciated more than 30% against the dollar since the start of 2021.

However, the market believes that the decline in the yen will force the central bank to act more quickly, especially if foreign exchange traders are betting on further declines in the yen.

“Given the recent performance of the yen, the Bank of Japan may need to reassess whether it needs to take a more hawkish stance at future meetings,” said Nathan Swami, head of currency trading for Asia Pacific at Citigroup in Singapore.

Currency speculators have been increasing their short positions on the yen, according to data from the U.S. Commodity Futures Trading Commission (CFTC).

To be sure, bets in interest rate markets are modestly sized, with many investors reassured by the more than 375 basis point gap between U.S. two-year Treasury yields and Japanese two-year yields as a strong fundamental driver of yen weakness.

“Many clients have been structurally eager to be long the dollar given the yield differential and the carry trade,” said Shafali Sachdev, head of investment services for Asia at BNP Paribas Wealth Management.

Still, the painful lesson of August's sharp appreciation of the yen, which caused the Nikkei's biggest one-day drop since 1987, has investors keeping currency strategy top of mind.

"I think the yen is as important as Japan's fundamentals," said Geoff Yu, a strategist at Bank of New York Mellon. Citi's Matsumoto also said that if the yen stops eroding the returns of the dollar, it may even be good for foreign investors in Japan. He said, "Because global investors have to worry about where the yen's depreciation may stop, they are looking for the bottom of the yen."

Article forwarded from: Jinshi Data