Citigroup: Yen arbitrage ends, "Fed needs to cut rates three times, at least six months"

On July 30th, Citigroup analysts Osamu Takashima AC, Daniel Tobon, and Brian Levine released a report stating that due to the recent strong momentum of the Japanese Yen's recovery, some investors believe that the USD/JPY exchange rate has peaked. Citigroup believes that although the recent rapid appreciation of the Japanese Yen aligns with Citigroup's medium to long-term outlook, it is still premature to make such a judgment.

According to Citigroup, historically, when the market reverses driven by Yen arbitrage, the USD/JPY will experience a significant decline.

During the 1998 Japanese financial crisis, the weakness of the Yen was reversed, with the USD/JPY reaching slightly above 147 Yen/USD in August 1998, then dropping to below 110 Yen/USD in January 1999, a total decline of over 30%.

During this period, the Federal Reserve only lowered its policy rate from 5.5% to 4.75%, then raised it back to 6.5% in mid-2000.

In June 2007, the USD/JPY peaked slightly above 124 Yen/USD, then dropped to around 95 Yen/USD in March 2008, and further dropped below 80 Yen/USD in 2011 due to the Federal Reserve's aggressive monetary easing policy in response to the global financial crisis, with a drop of nearly 40%.

However, in each case, the one-month interest rate spread of USD/JPY temporarily fell below the threshold of 4.75%. Currently, the interest rate spread is around 5.25%. Citigroup believes that six months is enough time for the foreign exchange market sentiment to recover and for Yen arbitrage trading to reappear.

The chart below shows the risk-return ratio of USD/JPY arbitrage. Citigroup points out that the ratio is currently in the range of 50%-60%, but after the periods when the market was driven by Yen arbitrage in 1998 and 2007, the USD/JPY only reached its peak when the ratio fell to around 40%. In 2002, when the IT bubble burst leading to a decline in USD/JPY, the ratio had already dropped to around 20%

Current Market Environment Relatively Stable

Citigroup stated that the market is most concerned about rapid price changes caused by accumulated short covering. Analysts also emphasized that the increase in volatility before the US election may lead investors to reduce risk exposure and need to be cautious about short covering of the US dollar against the Japanese yen.

However, Citigroup also pointed out that, even so, the current fundamental situation does not indicate such a significant change in the market environment, so it is wise to measure the market conditions based on the discussed interest rate differentials or arbitrage/volatility.

In the past two years, the US dollar against the Japanese yen adjusted by about 20 yen/dollar in the fourth quarter of 2022 and 10 yen/dollar in the fourth quarter of 2023.

The CitiFX Position Index shows that leveraged investors have built up long positions in the US dollar over the past two months, but have recently adjusted these positions, which is one of the reasons for the recent decline in the US dollar against the Japanese yen, but the positions are now basically back to neutral. Although there has been a net selling of yen, the current scale is not large.

Analysts expect that based on the current market conditions and interest rate differentials, the US dollar against the Japanese yen is expected to bottom out near the 200-day moving average and then rebound again. Analysts suggest that during the next rebound, it is wise to measure the level of selling strength.

Yen Still Has Room to Rise

Last week, Citigroup had expected that the US dollar against the Japanese yen would not fall below the 200-day moving average (currently around 151.1 yen/dollar), and over the next few months, the currency pair still has the potential to refresh recent highs and rise to 165 yen/dollar.

At the same time, Citigroup believes that the risk associated with the Bank of Japan's meeting on Tuesday tends to depreciate the yen, and in the next two to three weeks, there is room for the yen to fall to the 21-day moving average (currently around 157.5 yen/dollar). From a technical perspective, the 55-day moving average (around 157.5 yen/dollar on Tuesday) will shift from a previous support level to a recent resistance level, meaning that a rebound to this level is not surprising.

As of now, the US dollar against the Japanese yen is at 147.3 points.