We noted on Wednesday the growing debate over whether the yen’s recent decline is a temporary slide or a more serious, longer-term trend. As the yen continued its downward trajectory – reaching Y97.97 against the dollar – on Thursday, the consensus among the savvier currency analysts seemed to be swinging towards what Morgan Stanley’s head of currency research Stephen Jen calls a “more balanced market position” of about Y100 to the dollar – trading up to Y112 to Y115 by the year’s end.
In the view of the FT’s Short View columnist John Authers, the “economic logic is inexorable” given Japan’s increasingly “horrific” trade figures. Even if investors are feeling nervous, and they are, the yen has nowhere to go but down. Already, the currency has fallen 10.6 per cent against the dollar since its peak, and probably has further to go.
Jen meanwhile says the recent turn in USD/JPY is “likely to be genuine”:
While USD/JPY could still retreat on repatriation flows prior to Japan’s fiscal year-end (March 31), I suspect this is at best a five big-figure risk. The upside risk to USD/JPY could be 20 big-figures.
Besides various other reasons, a key explanation for the yen’s weakness is the sharp compression in Japan’s current account surplus, adds Jen:
As the global economy weakens and global risky assets stagnate, it is unlikely that USD/JPY and JPY-crosses trend significantly higher, though a step-rise in USD/JPY and JPY-cross to levels that correspond to more neutral market positions (could 100 be that level?) seem likely. When the global economy regains traction, whenever that occurs, I believe JPY crosses will trend higher. By end-2009, USD/JPY could reach 115.
Among other key reasons, in Jen’s view, are:
1. An external shock. Historically, as he notes, there has been a “perverse relationship” between the strength of the Japanese economy and the yen, that the JPY tended to rally when Japan’s economy was weak, and weaken when the economy was strong. One could explain this unusual relationship through inflation differentials, or that Japanese investors expatriate when their risk appetite is high and repatriate otherwise.
This time, however, the shock has come from outside Japan, whereas in the past Japan was undermined by weak domestic demand. This severe external shock has recently turned Japan from one of the largest net exporters to a trade deficit country: the last time Japan saw a trade deficit was more than 25 years ago.
Further, Japan’s income surplus — which has been larger than its trade surplus since 2005 — is likely to decline as well, in light of the move toward ZIRP in other countries and the dismal performance (particularly in JPY terms) of equity markets outside Japan.
2. Pension funds and lifers have not and may not repatriate. Jen says virtually all of the $1.8 trillion in cumulative private outflows from Japan since 1990 is still held overseas. Although some currency analysts say that expected changes to Japan’s domestic tax law could prompt Japanese corporates to bring billions of dollars in overseas retained earnings back into Japan, Jen says that domestic pension funds “may likely hold their positions rather than realising the losses and reinvesting in an equally uncertain domestic market”.
3. JPY is strong, in some ways. Whether the yen is strong or weak depends on one’s perspective, notes Jen. In nominal trade-weighted terms, the yen is at its strongest level since the BIS started computing this variable in 1994. In real TWI terms, due to Japan’s low inflation, the yen is about 15% weaker than its level in 1999-2000, and a massive 38% weaker than it was in March 1995. But against some other weak currencies, the yen look strong. Being an income-poor but assets-rich country, Japan has a great opportunity to acquire foreign assets at a massive discount now - and its asset-purchasing power may encourage outflows.
In conclusion, Jen sees USD/JPY and JPY-crosses making a ‘step-rise’ as the long-JPY positions are unwound:
This level of USD/JPY corresponding to a more balanced market position may be 100 or slightly above. For USD/JPY to keep climbing higher, steady and strong capital outflows will be required. But this can only happen if the world outside Japan offers interesting investment opportunities, which is unlikely to happen until the global economy regains tractions. Assuming the global economy does start to recover in 2H09, USD/JPY could trade up to 115 by year-end, and other JPY-crosses (GBP/JPY, KRW/JPY, BRL/JPY, and AUD/JPYP) offer interesting opportunities
Another currency strategist worth following, CBA’s Richard Grace, notes that the yen is being re-rated lower – he estimates Y112 to the dollar by year end. But it is difficult to be conclusive that the lower re-rating in the JPY is temporary or permanent, he says.
That is because the deterioration in Japan’s economy, the current account surplus, the widening CDS spreads and the political landscape all have a large cyclical or temporary element to their duration. Nevertheless, it is likely that USD/JPY is in the process of finding a new higher base above around 100.00 to 102.00 before moving higher. Our forecasts have had USD/JPY at 112.00 by year end since H2 last year (and 105.00 by mid year). At this stage, there is little incentive to change the forecasts.
Grace says the accelerating contraction in Japan’s economy has prompted some big companies to scale back their long-term investment plans in the country. At the same time, he adds, “there is now anecdotal evidence of FDI outflows from Japan”, which is contributing to yen selling.
Meanwhile, Japan’s sovereign CDS market is spiking higher, reflecting the accelerating downturn in the economy.
On a relative basis, the spike in Japan CDS market is much sharper than in the US, Europe (including the UK) and Australia. The cost of protecting JGBs in the CDS market has more than doubled to 1.21% of face value. The JPY is weakening as a consequence.
Another key factor not widely discussed is that foreign banks operating in Japan have excess reserves with the Ban of Japan “significantly above their level of required reserves”, says Grace.
Banks have been able to raise funds in the Japanese market at extremely low (and on occasion at negative rates) to place with the BoJ. Some of those cheaply raised funds are now being placed offshore resulting in JPY selling.
Then there is the US-Japan swap spread on three-year bonds, which has started to widen:
This is due to both increased US bond issuance and better relative health of US corporates compared to Japanese corporates. Q4 GDP numbers illustrated that the contraction in Japan’s economy was larger than in the US economy. The rise in US yields maybe modest, but it is still attractive to Japanese investors with USD/JPY at relatively firm levels. Interestingly, the 21 January low in USD/JPY of 87.13 occurred one week after the low in the US-Japan three-year swap spread
Related links:
The end of the yen’s safe-haven status? – FT Alphaville
Yen falls to lowest since November – Bloomberg
Tokyo’s share plan not seen as a magic cure - FT
Japan’s exports fall by 46% - Naked Capitalism
The yen’s rally ends – WSJ Heard on the Street
How and why the yen is the world’s strongest currency – FT Alphaville
And now a look at the yen – Long Room
Land of the Rising Sun – closer to the precipice – FT Alphaville