The Japanese yen (USD/JPY) has been the worst performing major currency in the first five months of 2022, diving to a 20-year low versus the dollar, slapped by Federal Reserve interest rate hikes that widened the gap with the Bank of Japan’s ultra-loose monetary policy.
But despite the extreme market pessimism surrounding the yen today, the Japanese currency might yet pull a wild card out of the deck if the world economy faces a recession. Historically, the yen has been a recession-proof currency that has functioned as a tactical hedge against periods of economic stagnation.
What are the factors that might resurrect the yen, in a market that has possibly prematurely sanctioned its demise?
What is your sentiment on USD/JPY?
US dollar-to-yen exchange rate (USD/JPY) skyrocketed in 2022
Japanese yen and recession: a positive track record
The Japanese yen (JPY) shows a positive track record during recessionary times.
Over the last six recessions in the United States, the yen has gained an average of 3.5% against the dollar, and just under 9% against the British pound (GBP/JPY). During the 2008 recession resulting from the subprime mortgage crisis in the United States, the yen gained about 14% against the dollar and 30% against the British pound.
This shows that the yen has historically served as an extraordinary recession hedge for investors.
|Jan 1980-Jul 1980||-4.7%||-1.4%|
|Jul 1981-Nov 1982||+4%||-7.3%|
|Jul 1990-Mar 1991||-3.2%||-9.8%|
|Mar 2001-Nov 2001||-2.2%||-1.5%|
|Dec 2007-Jun 2009||-13.7%||-30.9%|
|Feb 2020-Apr 2020||-0.9%||-2.6%|
|# of positive performance||1||0|
Credit: Capital.com, Data: Tradingview
Why does the yen’s value appreciate in a recession?
The principal driver by which the yen strengthens during recessions is the reduction of US interest rates, which is the exact reverse of the current situation.
Typically, during recessions, the Federal Reserve is called upon to support economic recovery by reducing interest rates, as declining consumption and growing unemployment tend to lower inflation.
This causes US Treasury yields to fall, lowering the rate gap with Japanese government bonds, and therefore easing the pressure on the USD/JPY pair.
It should also be remembered that Japanese investors are the largest holders of US securities, such as equities and bonds (Treasuries). When there is a recession, Japanese investors tend to bring their foreign assets back home – raising demand for their local currency and boosting the yen.
Japanese investors are the largest foreign owners of US Treasuries
Holdings of US Treasuries
|7) CAYMAN ISLANDS||277.4|
Credit: Capital.com; Data: Department of the Treasury/Federal Reserve Board
The yen is poised for vengeance, but when will it happen?
The rising probability of a recession provides potential for the USD/JPY exchange rate to fall from the current overbought levels. But there is no guarantee this will occur in the near future.
In the short term, the yen may continue to suffer from rising Treasury yields, which are backed by expectations of an increasingly hawkish Fed, as well as rising oil prices, as Japan is a net importer of energy commodities. Moreover, the fact that the Bank of Japan continues to stuck with its yield curve control policies – keeping Japanese bonds yields artificially low – does not support the JPY.
Whenever US inflation has topped 5% while unemployment fell below 4%, a US recession has always happened within eight quarters, and a yield curve inversion has forecast every recession since 1968, albeit with a one-year lag.
Both conditions have been met in the first quarter of 2022, but JPY’s contrarian bulls may have to wait a little longer before declaring vengeance theirs.