It’s time to talk about the Japanese Yen. Traders may have noticed the violent movements in USDJPY over the last few sessions. Longer term investors may have had the pair on their radar for a while, wondering whether there will ever be a trend reversal. So what’s going on between the Dollar and the Yen?

The crux of the issue is that interest rates on the Dollar are around 5.5%, whereas rates on the Yen are essentially zero. This presents an opportunity, for those in a position to exploit it. The opportunity is known as the carry trade. The carry trade involves borrowing the Japanese Yen at low cost, then investing the borrowed funds into currencies with a higher yield. The spread between the different interest rates dictates the profit margin.

In the case of the Japanese Yen and the United States Dollar, the spread is high enough to warrant a lot of attention in the world of finance. Investment firms borrow the Yen and buy the Dollar, benefitting greatly from the high yield offered by the greenback. This increases the price of the Dollar relative to the Yen, and this has been the main driver behind the surge seen in the USDJPY pair. The problem is that as long as the difference in interest rates persists, so does the selling pressure on the Yen.

But why are the respective interest rates so different in the first place? We need to take a step back in time in order to answer this. Economically speaking, Japan and the USA are in very different situations. The Japanese economy utterly collapsed in the early 1990s, following forty years of extreme growth. The decades of stagnation that ensued forced the Bank of Japan to lower interest rates on the Yen to non-existent levels in order to inject money into their banking system. The framework of monetary easing was designed to stimulate borrowing and investment, encouraging new growth in the beleaguered economy.

The results were mixed. Although the Japanese stock market eventually went on to reach fresh highs, the economy itself never convincingly gained any upwards momentum. This leaves the Bank of Japan with very few options. Any increase in rates will smother what fledgling growth has been achieved so far. The central bank needs to see progress in the form of higher wages, price inflation and economic expansion. So far, the signs are just not there, hence the current target rate of zero.

Now for the United States. The US economy experienced a small recession in 2020. To counteract this, the Federal Reserve lowered interest rates to zero, with the same purpose of stimulating borrowing, investment and growth. It worked. The American economy experienced a strong rebound, so much so that both the labour market and inflation figures started to show signs of overheating. This time, the response was to do the opposite and raise rates until the economy cooled off, hence the current 5.5% target rate.

This is how we arrived at the current situation, but what comes next? At this point, it may be worth reflecting on the consequences of having a weaker currency. Who cares if the Yen declines versus the Dollar? On the one hand, a weaker currency helps tremendously with the export market. Japanese goods become cheaper on the world stage, increasing money inflows into the economy, boosting local growth. A weaker currency also helps to pull in tourists, lured by the attractive exchange rate.

On the other hand, a weaker currency makes everything imported into the country more expensive. This includes very important things, such as oil. For a nation such as Japan, which is entirely reliant on oil imports, this presents a problem. Higher energy costs are obviously very detrimental to industrial production, potentially leading to cost-push inflation, which is what occurs when it becomes more expensive to manufacture goods. Unless the extra growth achieved thanks to higher exports is enough to cover the added expenses of manufacturing the goods, then there is a problem.

What is the Bank of Japan supposed to do? As we said previously, any rate hike would hinder the little economic growth achieved so far. Besides, even if rates on the Yen were allowed to rise to let’s say, one percent, the spread is still high enough to justify the carry trade. The gap would need to be closed considerably, which the BoJ simply cannot do.

Another possibility is for the Bank of Japan to buy the Yen on the open market, selling its foreign reserves in exchange. Judging by the sharp sell-off in USDJPY this week, this may well have already occurred. Changes in the bank’s current account balance appear to be confirming this theory, although markets will have to wait for any official confirmation.

Japan’s problems are exacerbated by the fact that the United States Federal Reserve continues to push interest rate cuts further down the road, meaning the pressure on the Yen is maintained for longer. Not an enviable situation for anyone.

The above explains the situation from the Japanese perspective, but misses something vital. The whole point of the carry trade is to use the cheap Yen to purchase currencies and assets abroad. What happens when this trade unwinds? All that cash will have to be paid back at some point; all the liquidity pumped into foreign assets must be repatriated back to Japan. What happens to the prices of those foreign assets when the time comes to cover the bill? Stock markets around the world beware.

Moreover, returning to the Japanese perspective one last time, what happens to the price of the Yen when the world rushes back into it to repay their loans? Any reversal in trend in USDJPY will trigger a rush to the exits as people sell their foreign reserves to buy back the borrowed Yen. If there is one undeniable truth behind all of this, it is that the world economy has never been more intertwined.

Markets experienced some measure of volatility over the past few sessions but ultimately stayed range-bound ahead of Non-Farm Payrolls later today. Jerome Powell’s comments earlier in the week reassured traders that an interest rate hike remained very unlikely, but some of his other comments continued to downplay the prospect of rate cuts any time soon. In no uncertain terms, the Federal Reserve Chair stated that inflation is still too high and that "further progress in bringing it down is not assured and the path forward is uncertain". Essentially, rate cuts are delayed, not cancelled.

The Dollar Currency Index showed some signs of weakness over the past two days but remains firmly above the 105 level for the time being. One contributor to the downwards pressure on the DXY is the sudden strength observed in the Japanese Yen. USDJPY fell a solid 2% on Wednesday, followed by a further 0.67% over the next session. A quick glance at the chart suggests the Bank of Japan may have finally stepped in to defend its currency against any runaway price action, although markets will have to wait for any official confirmation.

Appetite for further confrontation in the Middle-East continued to dissipate this week and with it any fundamental support for crude oil prices. Brent Crude fell below $84 a barrel on Wednesday, WTI now hovering around $78. Gold seems to have lost momentum one way or another for now, content to consolidate around $2,300 an ounce.

A roller-coaster week for stocks ended with even more drama last Friday, as Google and Microsoft published stellar earnings reports that were good enough to lead a market-wide rally. Tech stocks in general performed well, as evidenced by the Nasdaq Composite gaining a full 2% on the day. The S&P 500 lagged behind but still climbed a respectable 1% by the closing bell; the Dow Jones Industrial Average closed 0.4% higher.

On the other side of financial news scale, PCE numbers dropped on Friday, to little surprise overall. The Fed’s preferred inflation metric revealed a year-on-year increase of 2.8% versus expectations of 2.6%, while the month-on-month figures fell exactly in line with consensus at 0.3%. While only a small deviation, market participants are understandably becoming more and more sceptical of just how much of an interest rate cut we will see this year. Speaking of which, the Fed is due to announce an interest rate decision on Wednesday; no change from the current rate thoroughly priced in.

The Dollar seemed to capitalise on the sentiment, climbing half a percent on Friday, the DXY doing just enough to reclaim 106 points. Gold appeared content to remain out of the spotlight throughout most of last week, moving very little after Monday’s initial drop.

Strength in the Dollar contributed to woes in the Japanese Yen, which saw its exchange rate collapse on Friday, blasting through 156 and then all the way up to 158. The wording from the Bank of Japan last week inspired confidence in no one. The country’s central bank lowered its forecasts for economic growth this year, while data revealed lower than expected inflation figures for Tokyo. Given the huge discrepancy in interest rates between the Yen and the Dollar, traders see little reason to favour the former over the latter.

Troubling US economic data hammered stock prices lower on Thursday after Q1 GDP figures came in lower than expected at just 1.6% against a consensus of 2.5%. A worrying statistic in its own right, but further exacerbated by an unexpected increase in Core PCE Prices, which grew 3.7% in the first quarter of the year, also beating estimates. The combined figures paint a rather bleak picture as far as inflation is concerned. At the risk of stating the obvious, higher prices coupled with stagnant growth is not really on anyone’s wish list, and certainly not on the Federal Reserve’s.

Major indices opened low before spending most of the day clawing their way back up to somewhat more respectable levels. The Dow Jones was the hardest hit, keeping its neck above the 38,000 level to clock a rather pitiful 1% loss. The Nasdaq Composite did what it could but ultimately finished the session an uninspiring 0.64% in the red. The S&P 500 briefly dipped below 5,000 points before closing just under half a percent lower.

To add insult to injury, some of the earnings reports published this week have not exactly made for confidence-inducing reading. Meta revealed exorbitant operating costs that raised more questions about the company’s capacity to generate revenue, causing shares to plummet over 10%. Tech stocks in general suffered moderate losses as Microsoft, Alphabet and Amazon faced selling pressure.

Inflation fears pressured the Dollar slightly, pushing the DXY down a quarter of a percent, although currency traders are probably waiting for the Core PCE Price Index to drop on Friday before making more substantial bets. The Fed’s preferred inflation metric will no doubt shed more light on the developing stagflation narrative.

Simply put, the yield curve charts the yield earned on a bond against its time to maturity. It is a snapshot in time and changes shape regularly. Typically, the longer it takes a bond to mature, the better the yield. This is hardly surprising; if an investor buys a ten-year bond as opposed to a one-year bond, they should expect to receive a greater reward for doing so, otherwise why bother? This creates an upward sloping chart, considered a “normal” yield curve.

Due to market dynamics, yields on bonds are heavily tied to interest rates at large. The shorter the time to maturity, the tighter the correlation to the target interest rate set by the central bank of a nation. Short-term bonds, typically under one year to maturity, are used as a benchmark to price short-term borrowing and deposit rates. Longer-term bonds, typically a minimum of ten years to maturity, reflect the longer-term costs of borrowing and lending, such as for a mortgage.

The yield curve is a useful tool to quickly gauge interest rates over time, but also offers a glimpse into the confidence that investors have in a given economy. Put simply, if investors are losing confidence in the nation’s economic performance, they will prefer to divert funds to safer but lower-yielding, longer-term investments, such as bonds with 10+ year maturities. Due to increased demand, these long-term bonds increase in price, thereby lowering their yield (see part I for a more detailed explanation on this). This pushes the right side of the curve downwards.

The opposite is also true. Confidence in the economy translates to reduced demand in long-term bonds, because investors think they can get a better return on investment in equities or other short-term investments. Due to decreased demand, long-term bonds decrease in price, thereby increasing their yield. This pushes the right side of the curve upwards.

When reading financial news, one is likely to stumble upon chatter relating to the ten-year US treasury yield. This financial instrument is considered a particularly important benchmark for investors, given its impact on long-term borrowing rates and its susceptibility to global geopolitical sentiment. Variations in yield are reflective of variations in demand, which in turn give a reliable indication of overall market sentiment.

In rare cases, the bond market can experience something called a yield curve inversion. This means that short-term interest rates overtake long-term ones. We now have a chart that slopes downwards on at least part of the curve. This is something that has occurred recently in some parts of the world, due to central banks rapidly increasing interest rate targets to contain inflation. One of the effects of such a policy was to drag short-term bond yields above their longer-term counterparts.

On the surface this doesn’t make sense. How can investors earn a better yield for a shorter commitment? Why would anyone bother buying long-term bonds in such a situation? The answer is that those long-term rates are locked in for longer. No one knows how long the short-term high yields will last. An investor would have to constantly renew their position in the short-term bond market to maintain the high yield, which could go down at any time. This is called reinvestment risk and is a critical part of any trading strategy for larger investment firms.

During times of high interest rates, short-term investments are typically not as lucrative, due to a stronger currency and a restricted money supply. As explained above, a lack of economic confidence tends to put more buying pressure on longer-term investments, essentially reallocating money from the present and pushing it into the future. The inverted yield curve illustrates this phenomenon. So much so that an inversion of the yield curve has been a historically consistent predictor of economic recession.

The first two charts result from somewhat natural market dynamics. In contrast, the above chart is what happens when the central bank takes full control of the bond market by employing a tool called yield curve control. Yield curve control refers to the practice of a central bank purchasing bonds of specific lengths with the express purpose of lowering their respective yields to predefined targets. In essence, every central bank employs some form of YCC, although they are typically targeting the short end of the curve.

In the modern era, the term yield curve control is almost exclusively used in the context of the Japanese economy, as a result of the very specific conditions it has undergone since the 1990s. In an effort to drag the nation out of decades of stagnation, the Bank of Japan sought to inject some much-needed liquidity into its economy via the mass-purchasing of bonds and other assets. Money was pumped into the Japanese banking system and interest rates were pushed to zero and even below. Bond yields were crushed across the board, suppressing the yield curve on all timeframes in an effort to stimulate investment and growth in the beleaguered economy.

Unfortunately, this presented a particular problem for longer-term interest rates and their influence on things like pensions and mortgages. Many parties were understandably angry about the fact that long-term bonds were no longer yielding any kind of return on investment. In an effort to correct this, the Bank of Japan later allowed rates on higher timeframe bonds to rise slightly, while keeping yields on short-term bonds strictly below zero. Essentially, the yield curve was precisely tailored to specific targets, via the controlled purchasing of bonds by the central bank, hence the term yield curve control.

The use of yield curve control briefly gained more international traction during the Covid years, but remains a relatively novel and experimental tool. Even Japan has now abandoned the practice.

In conclusion, the yield curve quite literally paints the monetary landscape at a particular moment in time, offering insight into investor sentiment across a large timespan. As useful a tool as this is, it remains at least partially open to interpretation. Monetary policy has changed greatly in recent years, particularly since the 2008 financial crisis. As the monetary frameworks within which our economies operate continue to evolve, so too will our understanding of this vital tool.

Gold prices suffered heavy losses early this week as tensions between Israel and Iran continued to abate. Over the weekend, Tehran stated it had no retaliatory intentions against its long-standing adversary, despite further suspected attacks on Iranian soil. The reconciliatory tone did nothing to bolster the safe-haven narrative associated with gold, which has witnessed a meteoric rise over the past couple of months. The precious metal lost 2.7% on Monday and went on to endure further selling pressure on Tuesday following an unexpected drop in business activity in the US.

The S&P Global Manufacturing PMI fell to 49.9 in April compared to 51.9 for the previous month, technically placing it in contraction. The Global Services figures also came in lower than expectations at 50.9 compared to 51.7 in March. It is the first data print to show a loss of momentum in the US economy and will offer a glimmer of hope to investors betting on the Federal Reserve to finally nudge interest rates lower. Those hoping to see a more dovish stance from the Fed will also have their gaze firmly trained on Friday’s Core PCE Price Index numbers.

The data print was enough to push the Dollar Currency Index 0.4% lower yesterday, losing the 106 level it had maintained for most of last week. Despite weakness in the Dollar, pressure on the Yen did not subside, USDJPY edging as high as 154.8 ahead of the Bank of Japan’s interest rate decision on Friday.

Earnings week is upon us for many US companies, and already traders are piling into tech stocks, triggering rallies in all major indices with the Nasdaq Composite predictably leading the way. The index clawed back a decent chunk of the gains surrendered last week, gaining 1.1% and 1.6% over the past two sessions, the S&P 500 and Dow Jones also seeing a rebound after recent poor price action.