What accounts for the sudden renaissance of fundamental economic analysis among Yen traders? Since the Jan. 21 peak at 87.10, the Japanese currency has lost 12% against the Dollar in five weeks. The amount of the loss is comparable to the panic induced crash last September and October when the Euro lost 17% against the Dollar and the Dollar shed 14% versus the Yen.
Certainly, there is enough bad news out of Japan to justify such a reversal in the Yen’s fortunes if the developments had been unexpected. The 12.7% annualized contraction in fourth quarter GDP was a shock. But most indicators have been falling for months. Industrial production dropped 10% in January but it had already fallen 9.8% in December and 8.5% in November. Annualized Exports plunged 45.7% in January but they gave back 35.0% in December. The plight of the export driven Japanese economy in a world of contracting international trade is no surprise. Last year the World Bank estimated that global trade would decline 2.5% in 2009, the first drop in seventeen years. That estimate is probably higher now.
The reason for the sudden reversal in the Yen had as much to do with it its starting point at 87.10 and the process by which it had arrived there over the previous seven months than the sudden revelation of the perilous state of Dai Nippon from reported statistics.
The tremendous deleveraging in the Yen carry trade which began last July and ended with the panic selling in September and October was almost twice as violent in the Euro/Yen, the Aud/Yen, the Stg/Yen and the Nzd/Yen as the concurrent moves in the Euro and the Yen against the Dollar. The ‘safe haven’ Yen was no flight to quality. The Yen did not strengthen because the Japanese government paper was the safest boat in a sea of financial panic or because the Yen is the world’s reserve currency. The Yen was quite simply driven to those sub 100 levels because the trading flows from the end of the carry trade overwhelmed the market.
Economic statistics and comparative analysis played no part in the rise of the Yen; there was no interest rate analysis that excused a value for the Yen above 95.00 to the dollar last year. And there is none to justify 88.000 Yen to the Dollar in the current economic situation. When the pressure from the imploding carry trade was removed, it was only a matter of time before other more rational considerations returned to the Yen market.
The Euro, the Pound Sterling, Australian Dollar and New Zealand Dollar were all propelled to historic highs against the US Dollar at least partially by the carry trade and what is called ‘over dollar’ covering of cross positions. The Dollar itself had cruised to unsupportable levels against the Yen based on the same logic. In the summer of 2007 the Dollar /Yen was at 123.50, the Euro/Yen cross touched 169.00 while the Euro was in the mid 1.3000s against the US currency.
These flows were reversed by the convergence of world interest rates in the wake of the financial crisis and the explosion of the carry trade rationale. The forced withdrawal of many large speculative players from their carry trade positions and the deleveraging of much of the world financial system flooded the currency markets with sellers of Euro, Sterling, Australian Dollars, New Zealand Dollars and also sellers of the US Dollar against the Japanese Yen.
These flows were largely one way, that is they resulted from the exit of pre-existing long positions. One reason for the absence of any substantial retracement in the Yen crosses is the relative scarcity of new short positions on the way down. No short positions, no profit taking buying once the bottom has become clear.
Japan’s economic condition is much worse than the United States and there is little the Japanese can do to fix the situation. The Bank of Japan can print money to fight deflation but that will hardly support a stronger Yen; the government can try to gin up the economy with fiscal stimulus (and the BOJ’s new money) but that has not worked in the past and is unlikely to do so now. Exporters can hope the trough in world trade is not deep and prolonged, but there is nothing they can do to bring that about.
As a deliberate long-term economic policy, Japan has chosen exports over domestic consumption. The catastrophic collapse in GDP is the penalty of owning an export economy when no one is buying. The focus on exports over consumption is not a choice that can be reversed by discretionary government spending, central bank rate policy or a change of finance ministers. And behind these economic crosscurrents lurks the ageing and declining Japanese population and the toll that a shrinking consumer base exacts on domestic consumption and GDP growth. These are the true confines of the newly appreciated Japanese reality; the Yen has only begun to adjust.
FX Solutions, LLC
Chief Market Analyst