Fundamental Evaluation Series: USD/JPY vs. 2-year yield spread

This one pair has been at odds with yield divergence throughout early 2016 as the yen benefited from risk aversion and due to market participants’ doubts on BoJ’s abilities to ease policies further.

• It had shown excellent response to the yield divergence in the past, especially after Bank of Japan (BoJ) announced its quantitative easing program back in 2012. The close relationship lasted until summer of 2015.  US-Japan 2 year yield spread rose from 0.13 percent in 2012 to 0.72 percent by May 2015 and hovered there till October and the exchange rate reached from 76 to 126 in that same period.
• However, trouble started surfacing after summer. We guess it was triggered by surprise devaluation of the yuan by the Chinese central bank, People’s Bank of China (PBoC).
• The yield spread kept rising in favor of the dollar. The yield spread rose more than 30 basis point since summer, but, the yen has strengthened from 126 to as low as 98.
• After Donald Trump, the Republican candidate secured a victory in last year’s US election the exchange rate started to respond to the yield difference once more. After Mr. Trump’s victory, the yield gap jumped suddenly by more than 25 basis points and the yen weakened to 114 per dollar from as high as 101 per dollar.
• In our evaluation in August, we noted that both the spread and the exchanged rate have changed by a small amount. The spread narrowed by 6 basis points in favor of the yen and the yen has strengthened by 100 pips against the dollar. The spread was trading at 145 basis points (US-Japan) and yen at 109.9 per dollar.
• In our review in Mid-September, we noted that the spread has further widened by 13 basis points in favor of the dollar and the yen has weakened by almost 280 pips against the dollar, thus reducing the divergence to some extent. The spread was then at 157 basis points (US-Japan) and the exchange rate was at 112 per dollar.
• In our last review in late October, we noted that the yield spread has further widened by 17 basis points to 174 bps in favor of the dollar and the yen has weakened by more than 110 pips to 113.2 per dollar.

Since that review, the yield spread has widened further by 21 basis points to 195 bps but the yen has strengthened by 70 pips to 112.5 riding on risk aversion.

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