The JPY has been the strongest performing G10 currency in 2016, which is at odds with the strong pace of outflows. There is no single explanation for why this is the case, but we think three reasons are worth highlighting:
1. BNP Paribas FX Positioning Analysis has been showing a rapid buildup in JPY longs (Chart 2). Shorter-term FX investors have likely been aggressively adding JPY longs as a proxy hedge against broader market stress. JPY positioning stands at +33 (on a scale of +/- 50): the longest exposure within the G10.
2. Foreign investors turning net sellers of Japanese equities does not necessarily lead to a JPY outflow, as these positions were likely FXhedged – the ‘Abenomics trade’. Therefore, the unwind of these positions implies a simultaneous unwind of a short JPY hedge which offsets, and in some cases could more than offset if the underlying position has fallen in value, the underlying JPY selling.
3. Japanese domestic institutional investors could be starting to increase foreign currency hedge ratios.
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If currency hedging ratios increase, the next question is where foreign currency exposure will be concentrated. Chart 3 uses data from the Japanese Ministry of Finance and shows that, unsurprisingly, USD assets are the most likely, followed by EUR and AUD assets.
Finally, we highlight that the most recent release of Japanese MoF portfolio flow data showed that in the first week of the new fiscal year, Japanese investors turned net sellers of around JPY 1.5trn in foreign bonds, in contrast to the large outflows seen in the first three months of 2016. While this repatriation may only prove temporary, relating to balance sheet adjustments at the start of the new year, the fact that Japanese domestic investors were net sellers of foreign securities could help explain some of the recent acceleration in the pace of JPY strength.
We have maintained a bearish view on USDJPY through much of Q1 and heading into Q2. However, with USDJPY now trading close to our 108 Q2 target and with the JPY once again significantly outperforming the EUR, we think risk-reward is increasingly attractive for leaning the other way.
While further hedging of FX risk by Japanese investors is a possible catalyst for continued JPY gains, price action and our positioning data suggest this process is already well-advanced and, with rate differentials making hedging of FX expensive, there is scope for hedges to be unwound at these firmer JPY levels. Risks of a BoJ response to JPY strength in the form of additional easing have also risen considerably.
