One of the strongest performers against the USD lately has been the yen, with USDJPY now
probing 15-month lows. One of the main drivers has been the surging cost of FX hedging
(assume rolling 1 year FX forwards). The top-left chart shows the pick-up for a yen investor from
buying 10-year USTs and hedging the FX is now zero. However, investing in German debt has
been getting increasingly attractive for Japanese investors as the cost of hedging has not risen
by as much (top-right chart). The net effect of this is less selling of yen vs the dollar, but more
vs the euro. Hence USDJPY is weaker by 6.8% over the last 3 months, whereas EURJPY is only
lower by 0.6%. We can see this portfolio shift in the Commitment of Trader data in the bottom-left
chart. EUR vs JPY positioning for speculators is now the longest it has been since 2006,
apart from a blip in 2010. This leaves the cross prone to corrections.

How much stronger can the yen get? This largely depends on if the life insurers and other big
foreign-asset owners begin to raise their hedge ratios by buying yen. These hedgers tend to
react to previous yen behaviour, so a stronger yen leads to more hedging. This is a risk to the
inflationary goals of the BoJ, and will likely prompt a response from them before long.

(Click on image to enlarge.)

Source: Bloomberg, Macrobond and Variant Perception