Yen-JGB relationship reversed? Morgan Stanley: Now it's the weakening yen causing yields to rise.

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Morgan Stanley's latest research points out that a recent anomaly has emerged in the foreign exchange and bond markets: while the yen weakens, Japanese government bond yields are rising, breaking the traditional logic of "narrowing interest rate differentials—capital flows back—yen strengthens." Analysis suggests that speculative arbitrage trading, changes in fiscal expectations, and the global macro environment together shape the current market landscape.

The "Reversal" in the Yen-Bond Relationship

Recent market trends show the simultaneous occurrence of yen depreciation and rising Japanese government bond yields, rather than the traditional "bond yields rise, yen strengthens" pattern. Capital flow data does not indicate a clear return of Japanese domestic investors to Japanese government bonds, even though relative yields have increased.

From a capital behavior perspective, Japanese investment trusts continue to allocate to overseas assets, reflecting household demand to hedge against inflation and yen depreciation. Life insurance companies are reducing allocations to both overseas and domestic bonds, instead increasing overseas M&A and direct investment. The banking system manages yen and foreign currency assets separately, so there is no obvious "capital reflow" mechanism.

Although some foreign investors may buy yen temporarily when purchasing Japanese stocks, overall, recent yen weakness is not driven by securities investment flows.

Speculative Shorting and Arbitrage Trading as Key Drivers

The report believes that the main driver of recent yen weakness is speculative short positions, especially during London and New York trading hours. Although CFTC data cannot fully measure the scale of arbitrage, it still shows leveraged funds accumulating yen short positions, and BIS banking statistics and OTC derivatives data also point to a rebound in arbitrage activity.

The market also believes that Japan's fiscal policy may tend towards expansion, causing investors to price in higher risk premiums for the yen. Meanwhile, yen depreciation raises inflation expectations and exacerbates concerns about the Bank of Japan's slow policy normalization, leading to higher term premiums priced into medium- to long-term Japanese government bond yields.

However, as the market begins to speculate that Japan's Ministry of Finance might intervene in the foreign exchange market—even in coordination with the US—the expected returns on yen arbitrage trades are falling.

How Investors Interpret Yen Weakness

From the perspective of investors, the yen has become a convergence point for multiple macro themes, mainly including fiscal pressures, the return of inflation, and global arbitrage demand.

Firstly, fiscal issues are becoming a long-term theme for developed economies. Debt and deficit levels remain high, while political willingness to promote fiscal sustainability is limited. Similar rises in risk premiums have appeared in the UK and France, and now the expansion of term premiums in the Japanese bond market is seen as reflecting the same logic.

Secondly, the global inflation landscape has changed post-pandemic. The recovery of inflation in Japan is seen by some investors as the result of long-term loose policy by the Bank of Japan, but it also means real interest rates fall, further weakening the yen's attractiveness. Some investors believe the Bank of Japan's policy remains loose, and the yen's weakness reflects expectations that the BOJ is "behind the curve."

Thirdly, global demand for forex market arbitrage is rebounding. In the second half of 2025, with US dollar volatility declining, arbitrage trading has become an important strategy again, putting continued pressure on the yen as a funding currency.

Why Rate Hikes and Rising Yields Have Not Supported the Yen

The traditional logic holds that rising Japanese interest rates should attract capital back and boost the yen, but this is not happening in reality.

Pension funds are among the few institutions to have shown rebalancing inflows recently, but this is mainly for portfolio rebalancing, not active allocation changes. Investment trusts continue to allocate to overseas assets, while life insurers, affected by falling sales of savings-type products, have less investable capital.

The report suggests that claims of "large-scale Japanese investor selling of overseas assets and returning capital domestically" are clearly overstated by the market.

Meanwhile, foreign investors have become an important marginal source of funds for the Japanese bond market, especially in ultra-long-term Japanese government bonds. As hedged yields remain attractive, foreign inflows are supporting bond demand to some extent.

Direct Causes of Recent Yen Weakness

The report notes that the most obvious periods of yen depreciation are during London and New York trading hours, showing the greater impact of speculative short positions.

USD/JPY is persistently above the model-estimated "fair value," mainly reflecting two factors: first, the revival of US dollar term premiums; second, Japanese political uncertainty and expectations for fiscal expansion pushing up yen risk premiums.

Additionally, strong US economic performance and postponed rate cut expectations have extended the period of high US-Japan interest rate differentials, further increasing the attractiveness of arbitrage trading.

Potential Reversal for Arbitrage Trades

The report suggests arbitrage trades may be unwound if market conditions change. Potential catalysts include: increased geopolitical risks, weakening US economic performance, and easing concerns about Japanese fiscal expansion.

Additionally, the market is focusing on the risk of FX intervention. Recent "rate inquiries" by Japan's Ministry of Finance and cooperative actions from the US have been interpreted by some investors as signals for potential coordinated intervention.

At the same time, the market has started pricing in the possibility that the Bank of Japan may accelerate rate hikes, with the probability of an April hike now rising to 70%–80%.

Tail Risk: USD/JPY May Fall to 145

In summary, if global risk sentiment softens, fiscal expectations improve, or intervention expectations rise, even a single factor could trigger broader unwinding of arbitrage trades.

The report believes that in such circumstances, USD/JPY could fall to around 145 (close to the model's fair value), at least for a certain period.

Risk Warning and DisclaimerThe market carries risk; investment should be cautious. This article does not constitute individual investment advice and does not take into account individual users' unique investment objectives, financial situations, or needs. Users should consider whether any opinions, viewpoints, or conclusions in this article fit their particular situation. Investing based on this is at your own risk. ```