In the two months since Shinzo Abe returned to power as Japanese prime minister, USDJPY has rallied more than 12% amid promises that Tokyo would embark on a massive quantitative easing campaign and encourage currency weakness in a bid to boost its economy.
Since the inception of so-called Abenomics, the yen is in fact down against every global currency apart from the devalued Venezuelan bolivar.
Yet even the most dyed-in-the-wool yen bears would sure struggle to justify a move of this magnitude in terms of news or policy developments, says Adam Cole, head of FX strategy at RBC Capital Markets.
He notes that Japans ruling Liberal Democratic Partys previously touted policy of foreign bond buying appears to be slipping off the agenda, the search for a new potentially more dovish governor of the Bank of Japan is turning into an exercise in compromise, and US front-end bond yields, often seen as a catalyst for moves in USDJPY, have been trendless.
Investor flows cannot either explain the almost continuous selling pressure on the yen in the last two months.
Weekly flow data from Japans Ministry of Finance shows Japanese investors have been heavy sellers of foreign equities in all but one week following the election and during the yens slide.Indeed, as shown in the chart below, Japanese investors sold more foreign equities in the last month than in any four-week period in the datas eight-year history. Meanwhile, Japanese foreign bond buying, which peaked last summer, has trended back to negligible levels.
Post-election real money flow is positive for the yen Source: RBC Capital Markets, Bloomberg
The activity of foreign investors also does not explain yen weakness, with a sharp step up in foreign buying of Japanese stocks occurring after the election. Foreign bond flows have been mixed, but overall net capital flows have been into Japan since the election.
Thus, while the election outcome certainly shifted sentiment towards the yen, its subsequent slide appears to be driven by momentum and technical factors rather than actual news or real investment flows.
Indeed, investors say a large part of the rally in USDJPY has been triggered by the increased volatility in the market.
That has shaken option investors, many of whom cheapen the structures of their long USDJPY positions by selling knock-outs, which, as the name suggests, cancels their long positions if USDJPY trades higher through a certain level.
In a relatively low volatility environment, these structures work well, cheapening the cost of holding a long USDJPY position.
However, as USDJPY has surged higher, it has forced option players into the cash market to reinstate their long USDJPY positions, creating momentum and increased volatility that has produced a self-fulfilling spiral of yen weakness.
An easing of yen volatility could of course stem the tide of yen weakness, as it is at the core of the technical factors that have been driving the currency lower.
In the longer-term, however, it could be those investment flows, which so far have not been a source of yen weakness, that weaken the currency.
George Saravelos, FX strategist at Deutsche Bank, says if the authorities in Tokyo are successful in using monetary policy to boost the domestic economy, Japans Great Reflation trade should have a once-in-a-generation effect on currencies.
He notes that Japanese households have accumulated almost $9 trillion worth of cash over the last two decades, equivalent to 54% of total financial wealth.
Saravelos says a recovery in Japan, therefore, has the potential to significantly weaken the yen. Not only, he says, are Japanese portfolio outflows highly correlated to the the domestic business cycle, which has been improving, but a drop in real yields could see a more meaningful re-allocation to offshore assets.
Deustche estimates that every 5% shift in domestic deposits offshore would be equivalent to more than $400 billion worth of outflows from Japan.The potential for Japanese investors to send their cash abroad also has implication for other currencies.
Where Japanese outflows go matters
According to Deutsche, a rough proxy shows that Japanese flows have been dominating more than 10% of total inflows into the Australian dollar, emerging markets and the US dollar over the last eight years.
We dont highlight these figures to argue that he allocation trends continue, but to demonstrate that the marginal impact of the Japanese investor can be exceptionally large, says Saravelos.
The key point is that the Japanese can be driving FX price action for many years to come assuming of course that Abenomics now succeeds.
For the moment, the technical factors that drove the yen lower could easily reverse, but a more fundamental shift in the yen could be developing in the longer term.