Dillon Smoker Lanier

A little over a month ago I wrote Room to Breathe, a piece in which I noted how the recent Yen strength and 10-year JGB demand was making things easy for the MOF & BOJ. In the same piece I also predicted that the Yen would continue to strengthen as JGB/UST spreads narrow due to Fed rate cuts.

Room to Breathe was written a day before the FED cut interest rates, take a look at how the 10-year bond markets have reacted:

The day the Fed cut rates by 0.50%, the 10-year UST sold off, and hasn’t stopped yet. The 10-year JGB is up only moderately since the FED cut rates. Critically, this means the spread between 10-year treasuries in the US/Japan is expanding, not shrinking as I predicted.

This can be seen on the chart below, which has the 10-year bond spread (white) overlaid on the chart of USD/JPY.

You can clearly see why I predicted a narrowing spread between Japanese and US bonds would lead to Yen strength. The currency strength and bond spread move together.

What I just as clearly got wrong is that UST/ JGB spreads would narrow when the Fed cut rates. I guess the market views Fed cuts as inflationary, which has big implications.

After realizing the initial assumption that FED hikes would lead to yield spreads narrowing was wrong, I’m left with two questions:

1. Is rising UST yields driving the JGB yields higher?
2. Will future rate cuts also push long dated UST yields higher?

Going into the September FED rate cut decision, both Japanese and US 10-year treasuries were rallying. On the 0.5% announcement, USTs immediately sold off (yields up), but JGBs were down. Only a week later did JGB yields start moving up rapidly. It seems possible JGB yields are trailing UST yields due to the interconnectivity of global markets.

If future rate cuts push the US10Y to higher levels, something will have to give. I have no idea how likely this is. The US government can’t afford (literally or optically) to let long end bond yields get too high, so if this plays out, there will be some version of YCC implemented in the US.

So, do the MOF and BOJ still have room to breathe? It looks like space is running out.

Yen and bonds are not at danger levels yet, but both are heading that way. The 10-year JGB is at 0.97% as of writing, just below the flexible 1% area. The Yen has decisively broken above 150 USD/JPY and is heading towards 155 with momentum.

While I still see a path to a stronger Yen by end of year, the initial bond market reaction makes me much less sure. If long end yield spreads keep expanding the MOF and BOJ will be in a pickle.

Hayes swap theory will be back in play, we will see more Yenterventions by the MOF, and financial institution’s balance sheets will be back under stress.

It feels like the calm before the storm.

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