Hedge funds are heavily shorting the yen, could it drop to 165 at worst?

Zhitong Finance learned that leveraged funds have turned bullish on the USD/JPY, establishing positions that expect the currency pair to rise by 5% in the coming months. Following the Federal Reserve and Bank of Japan's policy meetings, which raised doubts about the pace of narrowing interest rate differentials between the US and Japan, hedge funds have aggressively bought call options on USD/JPY. The latest policy decisions have also dampened sentiment towards the yen, with the market now feeling less optimistic about its prospects.

On December 19, after the Bank of Japan made its decision, the trading volume of USD/JPY at the Depository Trust & Clearing Corporation (DTCC) surged, with total trading volume exceeding $23 billion, surpassing this month's high of about $15 billion. As of the time of writing, USD/JPY is the most active currency pair in DTCC options trading.

Mukund Daga, head of Asian FX options at Barclays in Singapore, stated, "Despite warnings from the Japanese Finance Minister and the Ministry of Finance, we are seeing hedge funds directly buying call options or digital call options on USD/JPY, expecting the currency pair to rise to the 160-165 range." USD/JPY closed at 156.31 last Friday, and as of the afternoon of the report, the yen fell 0.2% to 156.61 yen per dollar.

Other traders noted that many of the call option contracts have durations covering the next interest rate decisions of both central banks in January next year. On December 19, driven by a surge in demand for call options, the premium for hedging downside risks of the currency pair over the next two months (relative to upside risks) recorded the largest decline in three months. Hedge funds in Asia and Europe have been buying these bullish call options.

Sagar Sambrani, a forex derivatives trader at Nomura International in London, stated, "Due to the divergence in expectations between the Federal Reserve and the Bank of Japan, the upside potential for USD/JPY has rekindled interest in Q1 2025, supported by the overall strengthening of the dollar, with these trades expressed through direct digital and leveraged structures, which play a dampening role as spot momentum approaches the key level of 160."

Meanwhile, traders are cutting back on bets for a stronger yen. Ahead of last week's meeting, strategists were betting that 2025 would be a strong year for the yen. However, the market is now feeling less optimistic about the yen's prospects, as Bank of Japan Governor Kazuo Ueda indicated that there may be a delay in further rate hikes, while the Federal Reserve hinted at a slowdown in monetary easing next year.

Options indicators show that after the meeting, traders' bullish sentiment towards the yen has dropped to its lowest level in a month. The latest data from the Commodity Futures Trading Commission (CFTC) for the week ending December 17 shows that leveraged funds have also increased their net short positions in the yen to about 44,926 contracts, the highest level since July.

USD/JPY rose to a five-month high last week, breaking above the November high and opening the door for further gains. Strategists at Mizuho Securities and Mitsui Sumitomo Insurance have recently lowered their forecasts for the USD/JPY exchange rate. Mizuho raised its forecast for the USD/JPY exchange rate at the end of 2025 from 130 to around 145, while Mitsui Sumitomo Insurance currently expects 140, up from an initial forecast of 130

Foreign exchange strategists point out that if the Bank of Japan maintains interest rates unchanged before or after March next year, there will be a risk of further weakening of the yen. Some say that the widening interest rate differential may also bring back yen carry trades—investors borrowing funds in Japan and then allocating them to higher-yielding markets, a popular strategy that had ignited global markets earlier this year.

Charu Chanana, Chief Investment Strategist at Saxo Bank, stated: "The Federal Reserve's hawkish stance and the Bank of Japan's pause may provide yen traders with a new reason to 'continue' their actions. Both the Federal Reserve and the Bank of Japan are narrowing the yield gap, which has already been pushed beyond the first quarter, so yen appreciation may also be pushed to the second half of the year."

However, if the yen continues to weaken, funds will remain vigilant about possible interventions by Japanese authorities. Last Friday, following the depreciation of the yen, Japan intensified its warnings against currency speculation. Japanese Finance Minister Shunichi Suzuki stated: "The Japanese government is deeply concerned about recent fluctuations in exchange rates, including those driven by speculators. If excessive volatility occurs in the foreign exchange market, we will take appropriate action."