USD/JPY: Implications of narrower basis swaps – Deutsche Bank

Increase in hedged UST investment may have slight effect to curb a rise in USD/ JPY depending on how much it holds down long-term UST yields suggests Taisuke Tanaka, Strategist at Deutsche Bank.

Key Quotes

“USD/JPY basis swaps (BS) have been expanding at a noticeably faster pace than USD/EUR and USD/GBP in recent years, and spreads reached -95bp by endNovember 2016. However, it subsequently narrowed sharply in Jan-Mar, and has recently been trending near 30bp. Below we discuss the reasons behind this and our outlook and the implications for USD/JPY.”

“BS spreads expand depending on the difference between US and Japanese interest rates, and supply/demand balance in USD funding (including currency hedges to the USD). On the supply-side, (1) stronger regulations at US banks in recent years has effectively attached a premium to their USD supply. Other holders of USD should benefit from this premium, which means that an increase in the supply of USD should not equate to a one way widening of BS spreads. However, (2) some central banks/governments as major USD-based investors have tended to refrain from supplying their USD reserves to the swap market while their own currency has been too fragile.”

“That said, this alone should not generate a large difference in BS between the JPY, EUR, and GBP. At present, Japanese banks have not suffered a loss in confidence like European banks during the European debt crises in 2011-12. So, what are the conditions that have caused relatively wider USD/JPY BS spread?”

“Demand-side factors include (3) a dramatic increase in overseas direct investments and operations by Japanese companies, and (4) Japanese banks responding to the needs of these customers, and increasing overseas lending and bond investments as they seek higher returns than available at home under the BoJ's NIRP. Along with this sharp increase in USD asset holdings, on the liability front, Japanese banks are procuring USD via repos, deposits, issuing CP/bonds, and borrowings. (5) This assets/liabilities gap is larger for Japanese banks than for European and UK banks, and they use swaps and other derivatives to neutralize this mismatch risk, which could easily put pressure on BS spreads. (6) The life insurers and other Japanese institutional investors' preference for hedged foreign bond investments under the BoJ's NIRP has also pressured BS spreads.”

“(7) USD/JPY dropped sharply in 2016, increasing hedge selling demand among investors and companies. Moreover, (8) sharp outflows from US prime MMFs, which had been purchasers of CP issued by Japanese banks, due to regulations made it even more difficult for Japanese banks to procure USD.”

“Conditions turned around in 2017, with a rapid contraction of the negative USD/ JPY BS spread. We think this happened because Japanese banks made headway procuring dollars by increasing deposits, bond issues and other devices. At that time, this was compounded by the largest unwinding of USD/JPY hedges by Japanese investors since the Trump rally.”

“How should we look at developments going forward? Of the above factors, we expect (1), (3), (4), and (6) to remain largely unchanged. However, we expect that Japanese banks will continuously manage to lessen the impact of (5) and (8). We think that the impact from (2) could decrease partially and the impact from (7) could ease in the near-term (as long as our JPY-bearish view is correct). For interest rates, while the Fed will likely hike rates, we do not think that the BoJ will start normalizing its ultra-loose policy before the ECB. We do not expect the USD/ JPY BS spread, which has already reached the same level as in 2014-15 and as the EUR/USD’s, to narrow beyond this (unless there should be some credit shock in Europe). We see limited scope for the USD/JPY BS spread to further narrow from the current level given our outlook for deep-seated USD demand and a widening gap between Japanese and US interest rates.”

“How will this impact exchange rates? The recent decline in hedging costs (narrower BS spread) means Japanese investors can more easily invest in hedged USTs. Hedged UST flows themselves are neutral for the USD/JPY. However, if these flows reach massive levels across Japan, this could be a factor to restrain a rise in long-term UST yields. We believe this could in turn curb USD/ JPY upward momentum to some extent.”