The yo-yoing yen | World Finance #JapanFinance

Japan’s Prime Minister Fumio Kishida (right) with Bank of Japan Governor Kazuo Ueda as new yen banknotes are issued&nbsp

It may be overshadowed by the US dollar or euro, but the yen is the world’s third most traded currency, accounting for 13 percent of global foreign exchange transactions in 2022. Confidence is returning: the yen saw hedge funds inject nearly $5bn into bullish positions, the largest net long stance in almost eight years. The Bank of Japan’s (BoJ) decision to raise interest rates for the first time in 17 years has finally broken its longstanding ultra-loose monetary policies and opened the door to further reform.

Expectations for a yen recovery are growing. As of May 2024, scheduled earnings in Japan increased by 4.7 percent year on year – the fastest wage growth since 1992. Will this strengthening labour market be enough to support the yen’s recovery?

Its recent movements have been heavily influenced by geopolitical events like the Russia-Ukraine war and tensions in the Asia-Pacific region. Wealth management strategies have to change in line with the economic climate and central bank decisions, just as our collective investment choices affect not only world economies but the stability of societies as a whole. So how does Japan’s ability to adapt to movements in the yen affect global investment opportunities as well as domestic economic growth?

Understanding the yen’s legacy
The yen was born back in 1872, when Japan was brimming with optimism after the Meiji Restoration, abandoning centuries of isolation and encouraging modernisation. It was a currency that symbolised the identity of a newly self-confident nation embracing the wider world. Originally bound to the gold standard, it underwent major changes after 1945. With the world in chaos, the 1949 Bretton Woods system provided a lifeline for shattered economies desperate for stability. Under this new regime, the yen was fixed at 360 yen to the dollar, offering Japan security even if it constrained flexibility. In retrospect, this balancing act reflected the nation’s resilience.

By the early 1970s, Bretton Woods collapsed as the US abandoned the gold standard, and Japan let the yen float freely in 1973. The resulting combination of uncertainty and potential generated substantial movements in its value.

Geopolitical tensions, economic shifts and unexpected global events can all trigger tremors in currency values

The 1980s were turbulent for the yen, not least because of international agreements. The 1985 Plaza Accord intended to weaken the dollar, although this triggered a chain reaction that severely buffeted the yen. Although underpinned by Japan’s economic prowess, trade tensions with the US saw its value tumble to a low of 79.75 against the dollar by 1995. Unsurprisingly, Japan’s Ministry of Finance soon began directly buying and selling yen to stabilise its value and protect exporters from economic downturns.

More recently, the yen’s movements have been impacted by global financial crises and shifts in monetary policy, creating a challenging environment for managing future risk. As the Japanese proverb ‘fall seven times, stand up eight’ implies, responding with resilience is what counts.

Over the years, the yen has exemplified this resilience, especially in uncertain times. From the fallout of the 2008 financial crisis, when it surged to around 90.87 against the dollar as investors ran for safety, to its role as a haven during the Covid-19 pandemic, the yen has proved itself. However, its apparent stability remains vulnerable to external pressures, particularly when other nations grapple with inflation: the 2022 uplift in US interest rates battered the yen and widened the yield gap between Japanese and US government bonds. This growing divergence in monetary policies has made the yen more volatile and more subject to investor sentiment.

As of September 2024, inflation in Tokyo met the BOJ’s two percent target, signalling a return to growth and the promise of further rate hikes. However, the yen today is trading at about 147.83 to the dollar – the weakest rate in decades. This is no blip, but part of a bigger struggle for Japan, with geopolitical tensions, especially in the Asia-Pacific region, supply chain problems and the decision to keep interest rates near zero, all contributing factors.

A fragile position against inflation
Speculation about changes in Japan’s monetary policy suggests that the yen might bounce back, but with inflation creeping upwards and mounting global uncertainty, the situation is more precarious for consumers and policymakers alike, leaving the currency exposed. The defining moment came in July 2024 when the BoJ raised its short-term policy range from zero percent to a tentative 0.1 percent. While a stronger yen may temper inflation, it may also dampen Japan’s export-driven economy.

Dominic Schnider, Head of Global FX & Commodities at UBS Global Wealth Management’s Chief Investment Office, spoke with World Finance about how UBS adjusts its strategies to manage risk in terms of the yen. Schnider stressed that the UBS approach to currency management has not changed: investors are advised to hedge their exposure to G10 foreign exchange as a starting point in strategic asset allocation. He explained that wherever they foresee long-term appreciation, such as in Japan, UBS opts for unhedged positions, while constantly hedging their fixed income exposure to limit risk.

According to the Economic Complexity Index, Japan is the world’s most complex economy, due to its sophisticated infrastructure, diverse export base, advanced industrial sector and leadership in technologies like electronics, robotics and automotive manufacturing. Nevertheless, Japan’s low interest rates, domestic inflation challenges and total reliance on energy imports in a highly volatile global energy market all continue to influence the yen’s value. The widening gap between Japanese rates and those of other major economies has prompted the yen’s slide to a 24-year low: 132 against the dollar. According to JP Morgan’s 2024 forecast, the USD/JPY differential will continue to be influenced by market expectations of US Federal Reserve policy, rather than by the actions of the BoJ. While BoJ interventions could create short-term risks, they are unlikely to affect the main factors driving the yen’s depreciation. Despite the bank’s recent departure from negative interest rates, the yen remains tied to the US economy, as shown by a strong rally after a US CPI report in March.

In this environment, wealth management strategies need to stay flexible. In Schnider’s view, “The move in the yen and broader market implications was the result of several factors converging. First, we had a double surprise from the BoJ, and slowing US economic data. Second, investors were heavily chasing Japanese equities and were materially JPY short. Lastly, the valuation of the JPY stood at extremes, being out of balance with relative rates or from a PPP perspective. Current USD/JPY levels are more aligned with relative interest rate differentials.”

Schnider’s observations underline how quickly the market can be rattled when unexpected economic developments coincide with investor positioning, and while the yen’s recent correction could restore some balance, the situation remains fluid. Investors and wealth managers therefore need to monitor central bank actions in line with economic conditions, as developments could once again disrupt the currency’s stability at any time.

During a discussion about the recent foreign exchange market environment with the investment banking firm, Schnider explained how CHF and JPY tend to benefit from falling rates, particularly since these currencies are among the most reactive to US rate changes. For UBS, the Swiss franc has been their primary focus. In light of the current market conditions Schnider stated, “we played the unwinding of carry trade positions via our most preferred guidance in the CHF. From a positioning perspective, speculative accounts in the futures market have room to cut more CHF short positions compared to the JPY. We are therefore positioning the CHF in our mandates at present, both versus the USD and the CNY.”

Long-term investment strategies
The current challenge arising from currency volatility has to be addressed correctly for investors to protect their portfolios while seizing opportunities in an uncertain market. UBS recommended three essential strategies: “First, hold a diversified portfolio, so swings in one currency don’t alter overall investment performance. In that context, a global USD-based investor should not hold more than eight percent exposure to Japanese equities (eight percent high depending on the risk profile). A good equity and bond mix does help, as we have seen in 3Q. Second, have a strategic approach as to how to deal with FX exposure. This can go from fully hedged to hedged, depending on preference. And third, have a tactical investment framework, so you can take controlled exposure when FX dislocations emerge. Also make use of the option market to take asymmetric risk-reward playoffs (on both sides). Even if you are a long-term investor, considering extreme positions in the currency market requires investors’ attention.”

The yen’s movements have been impacted by global financial crises and shifts in monetary policy

Although spreading investment across a variety of different assets can mitigate sudden currency swings by allowing some areas to absorb the effect of shifting rates while others thrive, Schnider views managing FX exposure as critical to maintaining predictable returns and making sure investors are not caught out.

The real win, though, comes from finding opportunity in market instability. A flexible, tactical investment strategy allows investors to profit from changing conditions, turning uncertainty to their advantage.
After all, uncertainty is the name of the game. Geopolitical tensions, economic shifts and unexpected global events can all trigger tremors in currency values. It’s about remaining vigilant and proactive. Those who embrace change are better positioned to protect their assets. It is the ability to adapt proactively that makes the difference.