Will the JPY remain weak at the start of 2026?

JPY: Short positions reach highest level since Japan last intervened

The yen is starting 2026 where it left off last year on a weaker footing, with USD/JPY moving back up to recent highs at 157.89. At the end of last year, the yen failed to strengthen on the back of the BoJ resuming rate hikes in December and the Fed delivering its third consecutive rate cut. The price action continues to highlight that the relationship between USD/JPY and yield spreads has broken down in the near-term. The yield spread between US and Japanese 2-year government bonds narrowed by 33bps in December but USD/JPY has held around current levels throughout the month. With the Fed signalling they are likely to skip cutting rates at the next meeting in January and the BoJ not expected to hikes rates again until the middle of this year, it leaves the yen vulnerable to further weakness at the start of this year. Stable financial market conditions and improving investor risk sentiment are continuing to encourage the build-up of yen-funded carry trades. The latest IMM positioning data for the week ending 23rd December revealed that leveraged funds had significantly increased short yen positions to the highest level since June and July 2024. On that occasion USD/JPY hit a peak of 161.95 before Japan intervened on 11^th and 12^th July triggering a squeeze of yen-funded carry trades that resulted in USD/JPY plunging to a low of 139.58 by September. Recent comments from Japanese officials have strongly signalled that they considering intervening again to support the yen. The recent build-up of speculative short yen positions, and the divergence between USD/JPY and yield spreads could both be used to justify intervention.

The yen’s failure to strengthen at the end of last year also reflects ongoing concerns over fiscal risks in Japan under Prime Minister Takaichi which have not yet been addressed fully. After announcing a larger than expected supplementary budget totalling JPY18.3 trillion which would be funded by JPY11.6 trillion of additional JGB issuance, the government is now putting together a record budget for FY2026. On 26^th December, the government approved the FY2026 initial budget proposal at a cabinet meeting. Expenditures totalled JPY122.3 trillion which exceeds the total for the initial budget for FY2025 by JPY7.1 trillion. Due to increases in JGB costs and social security-related costs, the initial budget reached a record high for the second consecutive year.  JGB Interest and principal payments rose to JPY31.3 trillion up from JPY28.2 trillion in FY2025.  JGB costs account for JPY3.1 trillion of the JPY7.1 trillion in expenditures. After stripping out JGB costs, expenditures increased by JPY4.0 trillion which is exceeded by the increase in tax and non-tax revenues of JPY6.2 trillion. As a result, the primary budget balance is calculated to shift  to a surplus of JPY1.3 trillion.

Prime Minister Takaichi attempted to dampen concerns over the budget by stating that “while also taking fiscal discipline into consideration, we have worked on a budget that will harmonize a strong economy with sustainable public finances”. The budget proposal showed some vigilance by limiting new bond issuance to JPY29.584 trillion, below JPY30 trillion for the second consecutive year. The ratio of government debt to total fiscal revenue in the FY2026 budget is at 24.2% down from 24.9% in the previous year. The MOF’s plans for FY2026 calendar-based market issuance revealed a reduction in the size of super long JGBs. Issuance per auction for super-long JGBs was reduced by JPY100 billion each for 20-year, 30-year and 40-year maturities. Super-long JGBs have been relatively more stable over the past month. The 30-year JGB yield is little changed since the start of December trading at around 3.4% compared to bigger increases for sort-term maturities. The 2 and 10-year JGB yields have increased by 15bps and 20bps respectively over the same period. Recent price action indicates that fiscal concerns have become a bigger driver of yen performance in recent months. It is putting pressure on the government to address those fiscal concerns to restore greater stability in the JGB market and the yen in 2026.                    

BIG JUMP IN SHORT JPY POSITIONS IN DECEMBER

Source: Bloomberg, Macrobond & MUFG GMR

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com