LONDON, Dec 15 - A rare event of two G7 central banks moving in opposite directions on interest rates this week might seem like a slam-dunk currency bet.
But the sterling/yen cross has ignored the narrowing UK-Japan rate gap all year. These days, foreign exchange markets have more of an eye for fiscal policy risks and bond flows than for simple rate spreads.
Since the middle of last year, the difference between the main policy interest rates of the Bank of Japan and the Bank of England has narrowed by 165 basis points.
That squeeze will likely exceed 200 bps this week, with the BoE widely expected on Thursday to cut another quarter point to 3.75% and the BOJ set to hike another quarter to 0.75% the following day.
And yet, sterling is more than 1% stronger against the yen over those 18 months, and has rebounded about 5% since mid‑year to its strongest level against Japan's ailing currency in 17 years.
Much of the currency movement is due to broad yen weakness - a trend that's been both well-documented and politically controversial in Japan as a deliberate driver of inflation.
Since the COVID‑19 pandemic, Japan's currency has plunged: the BoJ's real effective yen index is down 30% to its weakest level in more than 55 years, with the yen flirting with dollar levels last seen in the 1980s.
But sterling's real effective index has also risen 10% since 2020 and is up another 1% this year. So this is not just a yen story; sterling has strengthened too.
Even if we assume currency markets are more forward-looking, bond markets tell a similar story. The 2‑year yield spread between UK gilts and Japanese government bonds has halved since mid‑2023 and is still falling, now back to levels last seen before the UK's disastrous 2022 budget. Yet sterling/yen is up 14% in that time.
"Real" yield spreads tell the same tale. Inflation‑adjusted 5‑year yields were widening in favour of sterling earlier this year, but have since narrowed by about 60 bps. And in very long maturities, where this year's biggest bond ructions have occurred, the 30‑year yield gap between the two countries has plunged by 120 bps since January.
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