<p>Morgan Stanley's latest research points out a recent abnormal phenomenon in the foreign exchange and bond markets: while the yen weakens, Japanese government bond yields are rising, breaking the traditional logic of &#34;narrowing interest rate differentials - capital inflow - yen strengthening.&#34; Analysts believe that speculative arbitrage trading, changes in fiscal expectations, and the global macro environment have collectively shaped the current market landscape.</p>
<h2><strong>The Relationship Between the Yen and Japanese Bonds Has &#34;Reversed&#34;</strong></h2>
<p>Recent market trends show that the depreciation of the yen and the rise in Japanese government bond yields are occurring simultaneously, rather than the previous pattern of &#34;rising yields, strengthening yen.&#34; Capital flow data does not indicate a significant return of domestic Japanese investors to Japanese government bonds, even though relative yields have increased.</p>
<p>From a funding behavior perspective, Japanese investment trusts continue to allocate overseas assets, reflecting the household sector's demand to hedge against inflation and yen depreciation. Life insurance companies are simultaneously reducing allocations to overseas and domestic bonds, while increasing overseas mergers and acquisitions and direct investments. The banking system, due to the separate management of yen and foreign currency balance sheets, does not exhibit a clear &#34;capital inflow&#34; mechanism.</p>
<p>Although some foreign investors may bring temporary yen buying when purchasing Japanese stocks, overall, the recent yen depreciation is not driven by securities investment capital flows.</p>
<h2><strong>Speculative Short Selling and Arbitrage Trading Become Key Drivers</strong></h2>
<p>The report suggests that the main driving factor behind the recent yen weakness is speculative short positions, especially during trading hours in London and New York. While CFTC data cannot fully measure the scale of arbitrage, it still shows that leveraged funds continue to accumulate yen short positions, and BIS bank statistics and over-the-counter derivatives data also point to a rebound in arbitrage trading activities.</p>
<p>The market also believes that Japanese fiscal policy may tend toward expansion, leading investors to factor in a higher risk premium for the yen. At the same time, yen depreciation raises inflation expectations and exacerbates concerns about the Bank of Japan's slow normalization of policy, resulting in higher term premiums being factored into medium- to long-term Japanese government bond yields.</p>
<p>However, as the market begins to speculate that the Japanese Ministry of Finance may intervene in the foreign exchange market, and there is even a possibility of coordinated action with the United States, the expected returns from yen arbitrage trading have begun to decline.</p>
<h2><strong>How Investors Understand Yen Weakness</strong></h2>
<p>From the investors' perspective, the yen has become a convergence point for various macro themes, primarily including fiscal pressure, the return of inflation, and global arbitrage demand.</p>
<p>First, fiscal issues are becoming a long-term theme for developed economies. Debt and deficit levels remain high, while political will to promote fiscal sustainability is limited. Similar risk premium increases have been observed in the UK and France, and the current expansion of term premiums in the Japanese bond market is seen as a reflection of the same logic.</p>
<p>Second, the global inflation landscape has changed post-pandemic. The rebound in Japanese inflation is viewed by some investors as a result of the Bank of Japan's long-term easing policy &#34;taking effect,&#34; but it also means lower real interest rates, thereby weakening the yen's attractiveness. Some investors believe that the Bank of Japan's policy remains overly accommodative, and the yen's weakness reflects expectations that the central bank is &#34;behind the curve.&#34;</p>
<p>Third, global foreign exchange market arbitrage demand is rebounding. In the second half of 2025, the volatility of the dollar is expected to decrease, and arbitrage trading is becoming an important strategy again, which also continues to put pressure on the yen as a funding currency</p>
<h2><strong>Why Interest Rate Hikes and Rising Yields Have Yet to Support the Yen</strong></h2>
<p>Traditional logic suggests that rising interest rates in Japan should attract capital back and boost the yen, but this has not materialized in reality.</p>
<p>Pension funds are among the few institutions that have recently seen a rebalancing inflow, but this is mainly due to portfolio rebalancing rather than active allocation changes. Investment trusts continue to allocate overseas assets, while life insurance companies are seeing a decrease in investable funds due to declining sales of savings-type products.</p>
<p>The report suggests that the notion of &#34;Japanese investors massively selling overseas assets to return domestically&#34; is significantly overestimated by the market.</p>
<p>At the same time, overseas investors have become an important marginal source of funds for the Japanese bond market, especially in the ultra-long-term Japanese government bond sector. The attractiveness of hedged returns has supported bond demand to some extent.</p>
<h2><strong>Direct Reasons for Recent Yen Weakness</strong></h2>
<p>The report points out that the most pronounced depreciation of the yen occurs during the London and New York trading sessions, indicating a greater influence from speculative short positions.</p>
<p>The USD/JPY exchange rate has long been above the model-estimated &#34;fair value,&#34; primarily reflecting two factors: first, the rebound in the dollar's term premium; second, political uncertainty in Japan and expectations of fiscal expansion raising the risk premium of the yen.</p>
<p>Additionally, strong U.S. economic performance and delayed rate cut expectations have prolonged the period of high U.S.-Japan interest rate differentials, further enhancing the attractiveness of arbitrage trading.</p>
<h2><strong>Potential Reversal of Arbitrage Trading</strong></h2>
<p>The report suggests that if market conditions change, arbitrage trading may face unwinding. Potential catalysts include: rising geopolitical risks, weakening U.S. economic performance, and alleviation of concerns regarding Japan's fiscal expansion.</p>
<p>Moreover, the market has begun to pay attention to the risks of currency market intervention. Recent &#34;exchange rate inquiries&#34; by the Japanese Ministry of Finance and coordinated actions from the U.S. have been interpreted by some investors as signals of potential coordinated intervention.</p>
<p>At the same time, the market has started to price in the possibility of the Bank of Japan accelerating its rate hike pace, with the probability of a rate hike in April now rising to 70% to 80%.</p>
<h2><strong>Tail Risk: USD/JPY May Retreat to 145</strong></h2>
<p>In summary, if global risk sentiment weakens, fiscal expectations improve, or intervention expectations rise, even the occurrence of just one of these factors could trigger broader unwinding of arbitrage trades.</p>
<p>The report believes that under such circumstances, the USD/JPY may have the potential to retreat to around 145 (close to the model's fair value), at least in the short term</p>

<p>The traditional relationship between the yen and interest rates is changing. Morgan Stanley pointed out that the recent weakening of the yen has instead driven up Japanese government bond yields, rather than the narrowing of interest rate differentials leading to yen appreciation. Signs of capital repatriation remain limited, with investment trusts continuing to invest abroad, and speculative yen shorts and arbitrage trades becoming key forces driving the exchange rate. In the future, if global risk sentiment weakens, the U.S. economy softens, or fiscal concerns ease, it may trigger the unwinding of arbitrage trades, posing a risk of a pullback for the USD/JPY</p>

- Morgan Stanley's latest research highlights an unusual phenomenon in the foreign exchange and bond markets, where the yen weakens while Japanese government bond yields rise.  
- Factors such as speculative short-selling, changes in fiscal expectations, and the global macro environment are shaping current market conditions, with little sign of domestic investment returning to Japanese bonds despite increased relative yields.  
- The report suggests that if global risk sentiment weakens or fiscal expectations improve, the yen could retrace to around 145 to the dollar due to potential liquidation of arbitrage positions.

Yen and Japanese bond relationship reversed? Morgan Stanley: It is now the weakening yen that leads to rising yields