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Stars are aligned for cheap hedging costs to drive yen gains

[NEW YORK] It's been getting cheaper for Japanese investors to hedge their foreign-exchange risk and that has the potential to push the yen higher in the coming quarters.

Bond yields around the world have slumped toward, or in some cases fallen below zero, and that has had the effect of reducing global hedging costs for investors. For Japanese institutions - which hold a lot of foreign assets - that may act as an encouragement to increase the amount of yen they buy on a forward basis to mitigate against exchange-rate fluctuation.

With implied dollar-yen volatility still above realised volatility levels, that's certainly a risk, which will be on many an investor's radar.

The yield slump also has the effect of making certain foreign debt instruments less appealing to own, which could also help buoy the yen by keeping more of investors money parked at home in Japan. Add that to the tendency for the Japanese currency to gain in times of stress, and the future for the yen could well be brighter than most forecasters predict.

While the median forecast of analysts surveyed by Bloomberg is for the yen to hover around the 105 per US dollar mark in the coming quarters, Royal Bank of Canada predicts that it will gain around 7 per cent against the greenback within the next year. The yen is currently around 104.70 per US dollar and RBC's Head of Currency Strategy Adam Cole is predicting a "drip feed" of yen buying from Japanese investors as they gradually re-hedge investments in dollar assets.

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Goldman Sachs Group strategists Karen Reichgott Fishman and Zach Pandl on Thursday cited low foreign-exchange hedging costs as one of several reasons that the yen may hold firm even if US Treasury yields move higher - a situation that has historically tended to weigh on the Japanese currency. Japan is the largest holder of US debt.

The cost for investors to hedge their overseas exposures has slumped as most central banks cut their official rates earlier this year. For example, the cost to borrow the greenback in exchange for the yen for a three-month period is near a five-year low.

JPMorgan Chase & Co, meanwhile, says the decline in yields is putting the brakes on Japan's purchases of overseas assets. That's reducing the pace of unhedged portfolio flows out of Japan and lowering what has been a long-standing hurdle for sustained yen appreciation.

On top of that, Japan's US$1.6 trillion Government Pension Investment Fund - the world's largest pool of retirement funds - is nearing a self-imposed cap on foreign allocations, which means that it may also have to slow down overseas investments or increase hedging.

The changing behaviour of non-Japanese investors also has the potential to provide the currency with a boost. Foreign institutional accounts, which had been purging themselves of Japanese equities through September, are now becoming buyers, with non-resident investment in the nation's stocks seeing net inflows in two of the last three weeks.

Goldman Sachs this month said Japanese stocks could outperform for reasons ranging from merger activity to the fact that foreigners have been underweight on the country's equity market. A flurry of Japanese debt buying by China in recent months may also support the currency.

To be sure, there are macroeconomic dynamics that suggest the yen will weaken from current levels. Persistent easing by the Bank of Japan has lifted the country's money supply growth rate to a 30-year high, and foreign-exchange traders maintaining a wary eye for the prospect of government intervention are often quick to take profits when the currency rallies.

Based on global terms of trade, swap spreads and equity prices, analysts at Commonwealth Bank of Australia suggest dollar-yen "fair value" is closer to 120.

However, should the yen strengthen due to increased hedging or interest in Japanese assets, this is a level that might well need rethinking.


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