Japanese yen shorts 'sit on hot coals'

Triggered by the Japanese authorities' intervention, the yen's rally has only intensified as short sellers - the force that pushed the yen to a 38-year low in early July - have rushed out of their positions.

The yen has risen 8% against the dollar in three weeks, a pace that has taken many market participants by surprise. Hedge funds and trend-following CTAs, which have built up short positions in the yen during quieter times, are facing losses or at least a new risk calculation, according to Reuters.

Shorting the Yen Suddenly Loses Its Strength

The yen has slid from 140 yen to the dollar in January to nearly 162 yen to the dollar in early July - a 38-year low - before recovering rapidly. This morning (August 2), the yen to the dollar was trading at less than 149 yen to the dollar.

At this level, speculators who have shorted the yen since the beginning of the year have lost half their paper gains, and the volatility has made them increasingly uneasy about their short positions.

Following recent monetary policy meetings in the US and Japan, with the two economies setting divergent interest rate targets, analysts and traders say the next move by leveraged speculators will be the deciding factor in market developments. And that could mean further gains for the yen.

When trend traders all catch the same market movement signal, an already large move becomes even larger and faster.

“When the yen rises below 152 yen to the dollar, CTA traders will start to act, not only reducing their long positions in the dollar, but actually start to short the dollar in the USD/yen pair,” said Malcolm.

Shorting the yen—a currency whose short-term yield has been near zero since the early 2000s—has been an interest-rate currency trade for years, and the potential for profit increases when the yen is steadily falling and exchange rate volatility is low.

Now the factors that had supported the expectation that the yen would be both cheap and stable are shifting. The recent rally in Japan’s stock market has encouraged investors to repatriate more funds from abroad, and Japan’s trade deficit has narrowed.

This year, Japanese investors have withdrawn a net 2.2 trillion yen, or $15 billion, from overseas stock markets, more than the net 621.2 billion yen they poured into foreign bonds, according to official data.

Along with that, within just 4 months, the Bank of Japan (BOJ) has raised interest rates twice and removed the yield curve control (YCC) policy - which is considered a "safety net" for short positions of the yen because it ensures that the yen interest rate remains at a super low level.

“We continue to believe that the yen’s weakness over the past two years is not indicative of a structural shift. The prolonged yen sell-off is cyclical in nature and could well reverse,” said Gareth Berry, a strategist at Macquarie.

Will the yen continue to appreciate?

Speculators have cut their yen short positions by the most since March 2020 in the past month. At $8.61 billion, the yen short position is now 40% below its seven-year high in April, according to data from the U.S. market watchdog.

“The technicals of the USD/JPY pair have reversed. With the BOJ becoming more hawkish, the market is now more interested in how much the BOJ can raise rates, rather than whether they will raise rates,” said Rong Ren Goh, portfolio manager at Eastspring Investments. Goh expects the yen to continue to rise, even as the market continues to short the currency.

To be sure, the fundamentals are still weak. Japan’s benchmark interest rate is about 5 percentage points below the US benchmark, and the market is forecasting a gap of more than 3 percentage points a year from now. But investors who remember the 1998 carry trade, when the yen rose from 147 to 101 per dollar in a matter of weeks, are retreating fast.

Hedge funds will avoid shorting the yen based on pure price action and not taking technical factors into account, and instead use options to bet on larger exchange rate moves, predicts Tareck Horchani, head of brokerage at Maybank Securities in Singapore.

Unleveraged investors have been buying the yen in recent weeks, with inflows at their strongest in five years, said Bart Wakabayashi, a fund manager at State Street. Fund managers are also shifting from being short on the yen to neutral.

“What everyone is interested in now is how the yen short position will play out and how long it will last. The yen has broken above the 200-day moving average, so a different technical picture may have been created,” Wakabayashi said.

According to the fund manager, the current technical chart shows that the USD is facing technical resistance at 150.5 yen per USD, and the pair is likely to fluctuate in the range of 145-150 yen/USD.