The yen’s surge this week to the strongest since 2014, which has confounded most currency traders and analysts, may be best explained through the prism of the bond market.No doubt, inflation expectations have declined in Japan, driving real Japanese yields higher against both U.S. and European ones, even as nominal Japanese yields fall into negative territory. But as Larry Elliott of the Guardian notes, the yen's surge against the dollar is reviving deflation fears:
Even with the struggles of the world’s third-biggest economy and expressions of concern by Japanese officials, the yen rallied more than 3 percent against the dollar this week, the most since February. The advance may seem even more improbable when considering Japanese government bond yields are negative for many maturities, ostensibly diminishing the allure of the nation’s currency.
Yet taking into account inflation-adjusted yields on both sides of the Pacific, 10-year Japanese debt has grown more appealing compared with Treasuries, according to Morgan Stanley and Societe Generale SA. And the banks point to this metric -- the narrowing advantage of the U.S. in terms of real yields -- to help explain why the yen is the best-performing major currency against the dollar this month.
"If real yields remain high, it will discourage the export of capital, which all else equal weighs on the dollar against the yen," said Calvin Tse, co-head of U.S. currency strategy for Morgan Stanley in New York. The bank forecasts the dollar will drop to 105 yen by the end of September.
The yen ended the week at 108.07 per dollar, after reaching 107.67 Thursday, its strongest since before Japan unexpectedly boosted its monetary stimulus program on Oct. 31, 2014. It surged more than 2 percent this week against major currencies.
Consensus Confounded
Japan’s currency has gained about 11 percent this year, in defiance of the consensus on Wall Street at the start of 2016. The median forecast among analysts surveyed by Bloomberg in early January was for the yen to weaken to 124 per dollar by the end of March.
Next week may offer more signs Japan’s economy is struggling. Forecasts call for reports to show year-over-year declines in machinery orders in February and producer prices for March. Sentiment among Japan’s large manufacturers was the weakest since mid-2013, the latest quarterly Bank of Japan survey showed.
Traders Shrug
Officials voiced warnings this week against the yen’s advance, which erodes the competitiveness of Japanese exports.
Japanese Finance Minister Taro Aso said rapid moves in the currency are undesirable, while Chief Cabinet Secretary Yoshihide Suga weighed in on the issue as well. Sparking skepticism, though, Prime Minister Shinzo Abe pledged to avoid “arbitrary” intervention.
Speculators in the futures market still ratcheted up bets on yen gains.
Hedge funds and money managers increased net bullish positions on the yen, according to data from the Commodity Futures Trading Commission. Net bets that the yen would appreciate tallied about 60,000 contracts for the week ended April 5, close to the highest since 2008.
“The yen’s recent strength has been driven by tumbling Japanese inflation expectations, which have driven real Japanese yields higher against both U.S. and European ones, even as nominal Japanese yields fall into negative territory,” Alvin T. Tan, a London-based strategist at SocGen, wrote in an April 7 report. “There is thus a fundamental momentum to the yen’s rise, at least in the near term.”
As expectations for long-term inflation have declined in Japan, its real yields have risen. The extra real yield on 10-year U.S. debt over Japanese counterparts has shrunk to about 0.6 percentage point from about 1.1 percentage points at the start of the year, data compiled by Bloomberg show.
Fears that Japan’s anti-deflation strategy is unravelling have intensified after a sharp rise in the value of the yen against the dollar prompted a concerted attempt by policymakers in Tokyo to talk down the value of the currency.
Japan’s finance minister, Taro Aso, raised the prospect of intervention on the foreign exchanges to counter what he called the “excessive” rise in the yen, which has gained 12% against the dollar since the start of 2016 to stand at a 16-year-high.
A weaker yen formed a central plank of the so-called Abenomics programme launched by prime minister Shinzō Abe in late 2012, since a depreciating currency pushes up inflation by making imported goods dearer.Let's stop right here to think a little bit about this means from a macro perspective. Right now, the U.S. dollar is weakening against the euro and more significantly, against the yen. Both Japan and the Eurozone are struggling with deflation, so as their respective currencies appreciate relative to the U.S. dollar, it hits their exports and heightens deflation in their respective economies.
But in recent months the yen has been climbing as a result of two factors. Financial markets believe that the Federal Reserve is wary of further increases in US interest rates and were unimpressed when the Bank of Japan failed to respond at its March meeting to the weakness of the dollar.
The result has been a flow of money out of the dollar and into the yen, which will make it even harder for the government in Tokyo to raise inflation – currently 0.3% – to the target of 2%.
“A rapid move toward either yen rise or yen fall is not desirable. It is desirable that currencies are stable at levels that match the economy’s fundamentals,” Aso said on Friday.
“As the G20 confirms, excess volatility and disorderly moves in the exchange market hurt (the economy), so we are watching currency moves with a sense of urgency. We will take necessary steps under certain circumstances,” he added.
Analysts at Capital Economics described Aso’s comments as “sabre-rattling” and said they were unlikely to be backed up with intervention on the foreign exchanges, in which Japan would buy dollars or sell yen to influence the level of the exchange rate.
The consultancy firm noted that Japan had signed up to a joint G20 pledge to refrain from competitive devaluations – attempts to secure a trading advantage at the expense of another country.
Instead, the Bank of Japan is expected to take further action to stimulate the economy in the hope that higher levels of activity will push up prices.
The options are limited, and amount to driving interest rates deeper into negative territory or expanding Japan’s quantitative easing (QE) programme.
But producing a package that will “shock and awe” the markets is not going to be easy. QE is becoming less and less effective, while the decision to push interest rates below zero has not gone down well with Japanese voters.
As a result, the risk is that the Bank of Japan’s response to a rising yen will be underwhelming when it meets at the end of the month.
The upshot of that would be a continuation of the yen’s rise, a threat of a further dose of deflation and the prospect of direct action on the foreign exchanges. With protectionism sentiment rising globally, that could start a currency war.
Then you have China, Japan's neighbor, which also relies on exports and has its currency, the renminbi (aka the yuan), pegged to the USD. China is also suffering from deflation which has showed signs of easing lately, but this may prove to be a temporary reprieve, especially if the USD starts appreciating again.
This leads to a curious situation which Charles Hugh Smith notes in his comment, Japan Desperately Needs A Stronger Dollar, China Desperately Wants A Weaker Dollar: The Fed Can't Please Both:
As the yen soars, Japan is being pushed into a self-reinforcing recession. After 20+ years of borrowing to fund fiscal stimulus, money-printing, bond-buying, etc., Japan has run out of options. Weakening the yen was the last best hope to boost exports and inflation.Go back to read my comment on markets defying central bankers where my buddy who is a great currency trader noted that the recent rise of global currencies relative to the USD won't last:
The strengthening yen is an economic crisis for Japan.
Meanwhile, the strengthening dollar pushed China into its own crisis. China's currency, the renminbi (RMB, a.k.a. yuan), is a special case because its relative value is pegged to the USD by Chinese monetary authorities. The peg was about 9 to the USD in 2005, and in the following decade, China pushed the yuan up to 6 to the dollar.
A currency peg means the pegged currency goes up and down with the master currency. As the dollar soared, it dragged the yuan higher, making China's exports more expensive. Given the stagnation of China's debt-bubble dependent economy, the last thing Chinese authorities wanted to see was a faltering export sector.
As the USD rose, the pressure to devalue the yuan also rose. If you think your money is about to lose 20% of its value due to a devaluation, what can you do to protect your wealth? Get your cash out of the currency that's being devalued and into a currency that's strengthening.
Just the possibility of a yuan devaluation has sparked an unprecedented capital flight of cash flooding out of China into USD and assets such as homes in British Columbia and chateaux in France. Capital flight is not a sign of a flourishing economy or evidence that the monied class trusts the currency or the economy.
Recently, China has taken baby-steps to devalue the yuan: not enough to trigger global panic but more than enough to trigger capital flight and deep unease.
As a result, China desperately wants a weaker dollar, as a weaker dollar will weaken the yuan and relieve the pressure on Chinese exports and demands for devaluation.
Many savvy observers have concluded that the recent G20 meeting in Shanghai led to an informal accord to weaken the dollar to prop up the global economy's shaky foundations - and most acutely, to relieve the pressure on China's yuan, which threatened to destabilize the faltering global economy.
But now the world faces the consequences of a weakening USD: a crisis triggered by a stronger yen. The USD has been yo-yoing in a trading range for a year, as the Federal Reserve has yo-yoed between hawkish declarations of rising rates (which make the USD more attractive and thus stronger) and dovish backtracking (we're never going to raise rates), which then push the USD lower.
No wonder the Fed is wobbling: it can't please both Japan and China. If the dollar plummets, China is delighted but Japan is pushed into crisis. If the USD continues its march higher, Japan is "saved" but China will be forced to devalue the yuan or watch its export sector decline.
As I often note, no nation or empire ever devalued its way to dominance or even prosperity. Rather, the devaluation of one's currency is the kiss of death, as everyone quickly learns your money is a ball that can quickly lose air or go flat.
Here's my take: Japan has no options left. China, on the other hand, can devalue the yuan as the USD strengthens. Indeed, a very good case can be made that China should devalue the yuan, as a practical adjustment to new global realities.
The Fed has a stark choice, and the 2-minute warning just sounded. It can break the informal Shanghai Accord to strengthen the USD to save Japan from the slow-moving catastrophe of a soaring yen, or it can let the USD weaken further to placate China and the commodity-dependent economies.
What it can't do is please everybody. This is the inevitable consequence of manipulating markets: you end up being unable to please anyone, because your constant manipulation has created unsustainable carry trades and speculative gambles.
The FX market is about to blow up in the Fed's face, and there's nothing they can do about it. What central banks fear most are markets that are not tightly controlled by central banks. The world's central banks are about to sit down to a banquet of consequences arising from seven long years of relentless manipulation.
"The way to think of currencies is the U.S. relative to the rest of the world. The U.S. leads the global economy by six to nine months. Go back nine months when the U.S. economy was doing well and its currency was rising. Now you see signs of the U.S. economy cooling and rallies in the euro, yen and emerging market currencies but I agree with you, it won't last. It's all part of a global RISK ON trade that will peter out and the greenback will once again start rising relative to other currencies."Why can't it last? Quite simply because countries like Japan that rely on exports can ill-afford a rising currency when they're deeply mired in deflation.
At this writing on Tuesday, the yen eased after Japan's finance minister reiterated that officials could intervene in the forex market to stem its steep rise, but analysts warned this could trigger a currency war in Asia.
Why? Because China and other Asian countries like Korea aren't going to stand idle if Japanese authorities unilaterally decide to intervene in the forex market to stem the yen's decline. And while some think Japan won't intervene without U.S. blessings, the truth is if the yen declines below 105, there will be growing pressure on Japanese authorities to intervene.
And this is where things get interesting. Go back to read my Outlook 2016 on the deflation tsunami where I warned you to keep your eye on emerging market currencies as this will be where the global battle on deflation takes place. What can spur a crisis in emerging markets? A rising yen that forces Japan to massively intervene in the forex market, sending shock waves throughout Asia.
And what happens if an emerging markets crisis ravages Asia? What else? Global investors scramble into good old U.S. bonds in a massive flight to safety which is another reason why I have a hard time buying the story that the Treasury rally will turn to a rout.
Moreover, as demand for U.S. bonds rises, it could spell the end of the decline of the greenback, placing more pressure on commodity currencies and stocks which rallied sharply since bottoming in late January. This is why I have a hard time believing oil will double by year-end no matter what OPEC decides to do.
There's something else going on here. The yen's surge has unwound the yen carry trade that hedge funds and big trading outfits use to leverage their positions in risk assets, like U.S. stocks and corporate bonds.
And with Mr. Yen, Eisuke Sakakibara, Japan's former Vice Minister of Finance now saying Japan’s currency may strengthen to 100 by year-end, it's no wonder Zero Hedge is predicting doom & gloom for the U.S. stock market (click on image):
And what happens if U.S. stocks get clobbered? More good news for U.S. bonds as global investors seek refuge to preserve their capital.
In fact, notice how despite the U.S. dollar weakening and oil and commodity prices bouncing higher, the yield on the 10-year U.S. Treasury bond keeps dropping as the yen keeps surging? The bond market is worried about something snapping out in Asia leading to a global crisis.
But it doesn't all have to be gloom & doom. If Japanese authorities do intervene in the forex market without spurring a currency war in Asia, traders that unwound the yen carry trade will wind it up again, leading to a massive RISK ON party in the U.S. market (except they will take profits from energy, commodity and emerging markets to invest in biotech and tech shares).
We shall see but right now, central bankers are walking a tight rope in their effort to avoid the global deflation tsunami which I've been warning of for years. The macro environment is very difficult, it's actually brutal which is why it doesn't surprise me to see Bridgewater's Pure Alpha fund down 7 percent so far this year. More evidence of why it's a requiem for hedge funds.
The key message of this comment for risk managers and global asset allocators is to keep your eyes peeled on the surging yen as it could trigger another global crisis.
Below, if Japan's central bank does move to stem the yen's recent strength, it might not work, warns Sean Callow, senior currency strategist at Westpac Bank.
Second, Boris Schlossberg, BK Asset Management, discusses Japan's central bank policy. And Lou Brien, DRW Trading strategist, explains why he thinks the U.S. economy is not doing particularly well.
Third, there's plenty of reasons to be nervous, says Phil Orlando, Federated, providing his outlook on the markets. But Steven Wieting, Citi Private Bank, pushes back a bit. I wouldn't be quite so bearish, says Wieting.
Lastly, an older educational clip where MoneyWeek's Tim Bennett explains the yen carry trade and why it's so popular with hedge funds. Great clip to keep in mind as you try to understand the yen or euro carry trade and how they impact risk assets around the world.