Australia’s second-largest pension makes big bet on yen strength

Australia's second-largest pension fund, Australian Retirement Trust (ART), has significantly increased its bet on the Japanese yen's strength against the US dollar. With assets under management of A$370 billion, ART has built its largest overweight position in the yen in years, anticipating that markets are undervaluing potential Bank of Japan interest rate hikes.

Senior portfolio manager Jimmy Louca explained that the fund has been adding to this trade over the past six months as the yen has weakened, reaching levels close to 160 per dollar. This move is unusual, as many investors are currently seeking to sell the yen. The yen experienced its weakest level in 40 years last month due to traders betting that the Bank of Japan will be cautious about raising rates while energy costs remain high.

Louca believes that the market has only partially captured the potential upside of the yen, as the impact of higher energy prices is already factored in, but the likelihood of Bank of Japan rate hikes appears to be underestimated. The odds of a BOJ rate hike in September are around 80%, according to swaps data, and the central bank may raise rates multiple times before energy prices complicate the situation, especially if the Middle East conflict escalates post-U.S. midterm elections.

ART's yen position is part of its dynamic asset allocation strategy, which applies across all its investment options. In the high-growth option, this yen trade accounts for about half a percentage point. Louca expects the fair value of the dollar-yen exchange rate to be around 150, potentially reaching the high 140s. Currently, the yen is trading at approximately 159.21.

Louca contrasts the central bank's approach to currency and bond markets with that of the United States. In Japan, the authorities are essentially buying time until higher interest rates can support the yen, while U.S. efforts to keep Treasury yields low are conflicting with underlying fundamentals. ART's bond portfolio is underweight in U.S. Treasuries, with a half-percentage point underweight, reflecting concerns about above-target inflation, robust growth, and competition for capital from the AI investment boom.

These factors may push term premiums and yields higher. Louca believes that the latest "Operation Twist" from the U.S. Treasury is merely delaying rather than preventing further upward pressure on yields, and he expects 30-year borrowing costs to continue climbing toward the 5.5% mark. While the U.S. dollar remains an important diversifier for ART's A$4.4 trillion pension system, Louca acknowledges the risk that efforts to suppress nominal yields could lead to inflation and weaken the dollar over time.