Is the JPY weakness over? Investors brace for a rebound

One of the weakest currencies in 2022 has been the Japanese yen (JPY). It declined against its peers so quickly that it took market participants by surprise.

Take, for instance, the USD/JPY exchange rate. It traded above 145, a level hard to imagine at the start of the trading year when the exchange rate sat well below 120.

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While the speed of the yen’s depreciation is nothing short of remarkable, one cannot stop wondering why it is so accentuated, given that inflation in Japan is far from levels seen in other parts of the world. The Bank of Japan’s monetary policy sure helps because by keeping the interest rate low, the central bank puts pressure on the yen.  

So is a correction in the cards? Or will we see some more JPY weakness in the months ahead?

Bearish bets against the JPY have reached record levels

At the start of September, bearish bets against the yen continued to mount. Asset managers have boosted their bearish bets to record levels, triggering short squeezes on the JPY pairs.

Whenever sentiment reaches such extremes, traders typically book some or all of their profits and wait for a correction in the underlying market trend.

Why is inflation so low in Japan?

Despite the currency being extremely weak, inflation in Japan is still tame. Several factors, such as the local culture of stagnant wages, contribute to it.

Also, Japan imports 30% less than the United States per capita. Moreover, energy consumption is about half of the US equivalent.

As such, factors that drive inflation higher in the United States and other parts of the world do not have the same impact in Japan.

What can the Bank of Japan do?

The Bank of Japan has struggled for many years to create inflation. A weaker currency surely helps, but no central bank is content with a rapid depreciation.

Therefore, the Bank of Japan may intervene to slow down the pace of the JPY depreciation. It may also repatriate the future interest income on its reserves. Also, it could hedge the government pension fund, which is invested in foreign assets.

Both measures will trigger a reaction in the currency market.

To sum up, the JPY pairs’ rally may have come to a stall, given how stretched the positioning is. As such, a temporary correction should not be ruled out.