Does the yen still work as a safe-haven currency?

We’ve had client interest in our views on whether we expect the yen to prove an effective hedge for risk assets going forward, given its ineffectiveness of late. In this blog we address the historical drivers and their current applicability.

Historically, several factors have contributed to the yen’s status as a safe-haven currency. The degree to which these factors apply varies, which in turn varies the effectiveness of the yen as a safe haven.

1. Prominence of the carry trade

The role of a currency in the carry trade often determines its risk-on or risk-off nature. As predominantly a funding currency, the unwinding of carry trades in risk-off periods has typically benefitted the yen. 

2. Current account surplus

Current account deficits must be financed via the capital account. During times of market stress, credit is harder to come by, and therefore more expensive.

Countries that run current account deficits may face difficulty financing their current account deficits and roll over existing external debt, causing concerns that can ultimately lead to depreciation. Japan doesn’t have this issue.

3. International investment position

Because of its sustained current account surplus, Japan has been able to build a substantial foreign asset base. During periods of crisis investors seek to bring their money home. That repatriation involves selling foreign currencies and buying the yen (for any unhedged positions), causing yen strengthening.

4. Reserve currency status

Two factors are in play here: liquidity and quality. When markets enter stressed periods, liquidity in financial markets decreases and investors seek higher-quality assets. Reserve currencies are those that are backed by credible institutions and are big enough to stay liquid during stressed periods. Japan scores well on both factors.

Lived experience also plays a part in investors’ thinking, whether rational or not, and the (broad) success of the yen as a hedge to risk assets conditions investors to expect that to persist.

Where are we today, and what’s next?

The yen has not been acting as a safe-haven currency this year. We have experienced a world of low interest rates, with very small interest rate differentials over the past 15 years or so. This had made the carry trade less attractive.

The US Federal Reserve’s relentless hiking to stamp out inflation has been a tailwind for the US dollar this year, but a headwind for risk assets.

Let’s examine the four factors again, this time focusing on where we are today.

1. Prominence of the carry trade

Short-term interest rate differentials have climbed from 0.3% at the turn of the year to 4.9% at the time of writing (based on forwards). The carry trade is alive and kicking when funded out of Japanese yen.

This has hampered the risk-off nature of yen so far in 2022, but wider interest rate differentials today are likely to support this property going forwards.

2. Current account surplus

The current account surplus has fallen from near 4% at the end of Q421 to 2.5% at the end of Q322.¹ Japan imports 90% of its energy,² and energy import prices have risen 74% since the start of the year.³

The overall reduction in the current account is small, but it masks the underlying composition. The trade deficit has weakened materially since the start of 2022 and is now deeply negative. The total is kept positive by large net earnings from the stock of foreign assets.

The reversal of energy prices is unlikely to be seen immediately in official numbers but should point to an improvement in the trade balance in due course, which would improve the current account surplus.

3. International investment position

Japan boasts net international investment (value of foreign assets minus the ownership of Japanese assets by non-Japanese investors) of $3.3 trillion, the single largest position of any country globally.⁴

4. Reserve currency status

According to IMF COFER data, the proportion of all foreign exchange holdings held in yen globally is 5.2%. At its peak at the start of 2021 this figure was 6%, but again a longer-term context is important. At its highest, this figure topped out at 10%. At its lowest in the post-2000 era, it bottomed at 2.8%.

The assertion that the yen is a reserve currency still very much holds, and much more so than for most of the post-2000 era.

With regards to liquidity, in the latest release of its triennial report on foreign exchange markets, the BIS calculates that the Japanese yen is the third most traded currency in the world, behind the euro and the US dollar.⁵

How will the yen fare in a risk-off scenario?

Ultimately, it depends what kind of risk-off scenario we are talking about. In rates-down risk-off scenarios, we have little reason to doubt that the yen will appreciate. In rates-up risk-off scenarios, the sensitivity of the yen to US interest rates makes it much more ambiguous.

The correlation of the yen and global equities will, in large part, be a function of the correlation of Treasury yields and global equities. That said, we believe that the skew is now in favour of the yen working as a safe-haven currency.

1. Source: Bloomberg as at 30 September 2022.

2. Source: Bloomberg, World Bank as at 31 December 2015.

3. Source: Bloomberg, as at 30 October 2022.

4. Source: Bloomberg, IMF as at 30 June 2022.

5. Source: Bank for International Settlements, as at 20 June 2022.