The Morning Commentary: The Yen and the Zero Interest Rate World
A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.
The Yen and the Zero Interest Rate World
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Andrew Kositkun Foreign Exchange Head Trader
The collapse in global yields has proved to be an inflection point for Japanese investments in overseas portfolios. From late 2019 to early 2020, Japanese purchases of U.S. equities topped a JPY 25 trillion annual pace. Since then, flows have slowed to the point that Japanese investors net sold foreign assets every week in September.
While de-risking ahead of the U.S. election accounts for some of the overseas investment drop, the mix of higher Japanese real yields and lower nominal rates globally have also played a key role. Historically, real rates have been a less dominant force in influencing investment flows, as nominal rate spreads were wide. With nominal rates compressing globally, it isn’t surprising that inflation adjusted returns have become more important.
Adding to the slowdown in flows is the fact that pension funds — the largest source of Japanese bond outflows — have largely achieved their allocation target for unhedged foreign bonds. Further, pension funds have begun to finance their foreign debt by taking profit on foreign equities that results in an offsetting rotation from stocks to bonds. On net, the reduction in yen outflows lowers the bar for yen appreciation.
Japan’s real yield advantage not only slows outflows but has also attracts foreign inflows. Specifically, reserve diversification flows have become a source of yen demand. The yen’s share of global reserve allocations has roughly doubled since the Great Financial Crisis. This growth has slowed in recent quarters, but the latest data shows growth picking up again. To this point, China’s purchase of Japanese government bonds has hit a four-year high. It is very likely that a portion of these flows represents FX reserve diversification away from U.S. treasuries and should be a persistent factor pushing for yen appreciation.
HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT:
Markets continue to monitor polling data. Historically, the advantage for the leader in national polls tends to narrow over the last two weeks ahead of Election Day, and this year is no exception. As a result of this narrowing in the polls, post-election implied volatility remains modestly elevated. Looking forward, changes in the polls should continue to drive markets, but this sensitivity could be lesser than prior elections due to the record number of early votes (about 50 million, or 37% of 2016’s total turnout) and the low share of undecided voters.
Senators left Washington, D.C., after confirming Amy Coney Barrett to the Supreme Court 52-48 on a party-line vote. Justice Barrett took her first oath at the White House last night and can start work today after taking a second oath in a private ceremony. Regarding fiscal stimulus, the chance for additional aid was already bleak but is nearly impossible now with senators gone and both sides far apart on too many issues to resolve quickly.
Global geopolitical tensions continue to rise, with Taiwan’s Defense Ministry stating that Chinese military aircraft entered Taiwan’s Air Defense Identification Zone last night. While this has happened before, tensions are clearly escalating after the U.S. approved the sale of anti-ship missiles to Taiwan.
Dissent in the U.K. government is growing. Prime Minister Boris Johnson’s Internal Market Bill initially triggered rebellion within the Tory party, with the anti-lockdown rebellion now gaining momentum. News reports indicate that more than 50 Tory members have signed a letter demanding an exit path from restrictive measures put in place in the north of the country. Despite the protests, COVID-19-related restrictions are likely to increase as U.K. hospitalization rates continue to rise.
China has removed the counter-cyclical factor in its yuan fixing in order to establish a rate that better reflects market forces. The counter-cyclical factor was introduced to give China’s central bank more room to lean against currency moves. Ultimately, this isn’t a directional signal, but part of a plan to increase flexibility in the exchange rate in general at a time when there isn’t serious pressure on the yuan. However, in the current context, removing the counter-cyclical factor signals that the central bank will not push back on yuan weakness. This latest move, combined with other recent actions and statements from officials, suggest growing discomfort with the stronger yuan.
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