LONDON - A rare event of two G7 central banks moving in opposite directions on interest rates this week might seem like a slam-dunk currency bet.

But the sterling/yen cross has ignored the narrowing UK-Japan rate gap all year. These days, ‍foreign exchange markets have more of an ‍eye for fiscal policy risks and bond flows than for simple rate spreads.

Since the middle of last year, the difference between the main policy interest ​rates of the Bank of Japan and Bank of England has narrowed by 165 basis points.

That squeeze will likely exceed 200 bps this week, with the BoE widely expected on Thursday to cut ⁠another quarter point to 3.75% and the BOJ set to hike another quarter to 0.75% the following day.

And yet, sterling is more than 1% stronger against the yen over those 18 months, and has ⁠rebounded ‌about 5% since mid-year to its strongest level against Japan's ailing currency in 17 years.

Much of the currency movement is due to broad yen weakness - a trend that's been both well-documented and politically controversial in Japan as a deliberate driver of inflation.

Since the COVID-19 pandemic, Japan's currency has plunged: the BoJ's real effective yen ⁠index is down 30% to its weakest level in more than 55 years, with the yen flirting with dollar levels last seen in the 1980s.

But sterling's real effective index has also risen 10% since 2020 and is up another 1% this year. So this is not just a yen story; sterling has strengthened too.

Even if we assume currency markets are more forward-looking, bond markets tell a similar story. The 2-year yield spread between UK gilts and Japanese government bonds has halved since mid-2023 and is still falling, now back ⁠to levels last seen before the UK's disastrous 2022 budget. ​Yet sterling/yen is up 14% in that time.

"Real" yield spreads tell the same tale. Inflation-adjusted 5-year yields were widening in favour of sterling earlier this year, but have since narrowed by about 60 bps. And in very ‍long maturities, where this year's biggest bond ructions have occurred, the 30-year yield gap between the two countries has plunged by 120 bps since January.

Still, sterling/yen keeps rising.

JAPANESE APPETITE FOR GILTS

On the surface, the big macro numbers offer no smoking ​gun either.

Latest OECD forecasts show UK and Japanese real GDP growth roughly on par this year, with Britain only slightly faster over the next two years. Inflation in both economies is seen converging to 2.1% by 2027.

So, if interest rate gaps do not adequately explain the currency markets, then the different tacks on fiscal policy are doing some of the heavy lifting.

For all the political noise around Britain's budget last month, UK fiscal policy is tightening, while Japan's new Prime Minister Sanae Takaichi has pointedly embarked on yet another government spending spree.

Those contrasting budgetary moves help explain why the two central banks are diverging this week.

Not unlike Britain's 2022 experience, currency markets may now be reflecting a risk premium to Japan's renewed stimulus into its already gigantic debt pile and concerns that Tokyo may eventually lean on the BoJ not to tighten further.

Whatever the rationale, the behavior of Japanese bond investors suggests they are the major factor in the cross-border flows and that may be a big reason for the exchange rate shift.

Foreign investors own almost a third of the gilt market, and Japanese investors make up almost a third ⁠of that. In October alone, Japanese funds bought the largest amount of UK sovereign bonds in over four years. With ‌still almost a two-percentage-point pickup on UK 30-year debt over those at home and 270 bps on two-year paper, it appears Japanese investors were already buying before the tight British budget and as BoE rate-easing bets ramped up.

The desertion of their domestic bond market during the political turbulence in Japan that month was an equal driver.

In the end, it is investment flows - rather ‌than the direction of rates ⁠alone - that have won out in the currency market.

The opinions expressed here are those of the author, a columnist for Reuters

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(by Mike Dolan; Editing by Marguerita Choy)