Hedging demand surged releasing key signal. Is the good time for yen arbitrage trading over?

The demand for hedging the Japanese yen against the US dollar exchange rate risk is increasing, which may be the first signal that the upward trend in Japanese interest rates is affecting arbitrage trading. After the Bank of Japan raised interest rates in December and hinted at possible further tightening of monetary policy in the future, Japanese interest rates have risen to their highest levels in decades - the five-year Japanese government bond yields have risen to about 1.5%, a level not seen since 2008. Although nominal interest rates have risen, breakeven inflation expectations have also increased, indicating that Japan's real interest rates are still deeply negative. Overall, to turn Japan's real interest rates positive, the five-year nominal interest rate needs to rise to about 2.5% or higher, which is the breakeven inflation rate assumed and is the difference between the current nominal interest rate and the real interest rate. This means that if the Bank of Japan's ultimate goal is to push rates into positive territory, Japanese five-year rates may still need to rise significantly in the coming months. Higher Japanese five-year rates would mean a significant narrowing of the US-Japan interest rate differential, unless US rates rise in sync with or even faster than Japanese rates. However, as the market expects the Federal Reserve to cut rates in 2026, the likelihood of US rates rising faster than Japanese rates seems unlikely. Forward rates The five-year Japanese yen forward rates are currently at a critical level, suggesting that a breakthrough may be imminent. If the spread between overnight rates continues to narrow, it may put additional pressure on forward rates, causing them to compress further. An increase in forward rates implies that the yen may strengthen in the future, and expectations of yen strength may be a driving factor in increasing hedging activities, thereby boosting demand for dollar funding. Currently, the five-year cross-currency basis swap has stopped its upward trend and turned more negative, which may be a signal of increased dollar hedging activities. Ultimately, whether this trend continues largely depends on whether the yen can strengthen relative to the dollar. Despite recent rate hikes and narrowing differentials, the yen is actually weakening. Such a divergence between interest rates and exchange rates has been rare since 2020. Increasing hedging demand One reason for the weakening of the yen may be that investors are increasing their exposure to US dollar-denominated assets without hedging against currency risks. However, as long as investors can still get additional returns from US stocks, arbitrage trading may continue to exist. Over the past four years, there has been a high correlation between the five-year cross-currency basis swap and the performance of the S&P 500 index, and yen arbitrage trading seems to have also driven the rise in the US stock market. In the context of the yen weakening over the past four years, hedging has not been necessary, so the cost of dollar funding has continued to decline. However, since the end of October, the cost of dollar funding has increased, leading to a noticeable deviation between the recent rebound in the S&P 500 index and the cross-currency basis swap. Similar situations have occurred in the past, and it is still too early to determine whether the downward trend in the cross-currency basis swap will continue or reverse. However, if Japanese interest rates continue to rise, the yen will eventually begin to strengthen, and hedging activities will increase accordingly, marking the end of arbitrage trading - at least the prevalent type of arbitrage trading in recent years.