Making sense of the soaring yen amid financial market turmoil

DURING the first 11 days of February, the Japanese yen has soared by more than 7 per cent against the US dollar amid turmoil in global financial markets. This was not supposed to happen. On Jan 29, the governor of the Bank of Japan (BOJ) Haruhiko Kuroda surprised the markets by introducing a negative interest rate policy, for the first time (after having said earlier that such a policy would not be suitable for Japan).

This was designed to achieve two key goals, both of them related: push down the value of the yen and raise inflationary expectations. The policy seemed to work at first - for all of three days. The yen weakened and the Japanese stock market enjoyed a sharp rally. But then, as global financial market turmoil intensified, it all went into reverse. The yen soared and Japanese stocks dived. The Nikkei is now at its lowest point since October 2014.

Currency market movements often defy explanation. The forces bearing on them include not just interest rate differentials and economic fundamentals (which are sometimes ignored), but also capital flows, sentiment and herding behaviour. There are many theories to explain why the Japanese yen has behaved as erratically as it has during the last 11 days. One is that it has been a major funding currency. Before the BOJ embarked on its negative interest rate regime, it held interest rates at close to zero continuously since 2010 and at very low levels just above zero for most of the previous 10 years. Unlike the case with the US Fed, there was virtually no risk of an interest rate hike.