What's happening with the Yen?

The following is an extract from commentary that was posted at www.speculative-investor.com on 30th December. 

Are there any Yen bulls left in the world? One of the most amazing things about the currency market action over the past few weeks is that the Yen has fallen almost every day despite almost everyone in the world being bearish on it. Normally such unanimity of bearish opinion in a market results in at least a short rally because, after all, if the vast majority is already bearish then there should be an absence of new sellers. Not so in the case of the Yen.

There are a lot of good fundamental reasons for a weak Yen. Japanese stock and real estate prices have been trending lower for the past 12 years, the Japanese economy is contracting at a faster pace than the US economy, Japan's bankruptcy rate is accelerating higher, the problem of massive non-performing loans remains within the Japanese banking system, and Japan's Government debt is much higher (as a percentage of GDP) than that of any other first-world country. However, these problems have been around for years and therefore don't really explain why the Yen is collapsing now.

In our view, the Yen's relentless slide has less to do with economic fundamentals and more to do with the 'Yen carry trade' (borrow Yen at an interest rate near zero, exchange the Yen for Dollars and invest the proceeds in higher-yielding US Government debt). A trader who does the 'Yen carry' is short the Yen, long the Dollar and hoping to pocket the interest rate differential between the US and Japan plus a profit on a decline in the Yen's exchange value. The main risk associated with this trade is that the Yen will strengthen against the Dollar by more than the interest rate differential between the US and Japan. However, as we noted in our Dec-17 commentary a weakening Yen meshes with the current goals of both the Fed and the BOJ (the US needs a strong Dollar to conceal the evidence of inflation and the BOJ wants a weak Yen to help Japan export its way out of recession). When two of the world's 3 major central banks are effectively underwriting a trade, the risk associated with that trade is substantially reduced. In particular, it makes no sense to bet against a central bank that is determined to weaken its currency since a central bank's power to devalue is equivalent to its power to create money out of nothing (it is unlimited). 

So, the Yen is most likely being driven lower by the renewed popularity of the Yen carry trade. Since this trade has the implied support of both the Fed and the BOJ it is perceived to be almost riskless and will undoubtedly remain popular until something happens to alter the Yen's trend. In the mean time there is certainly no shortage of negative economic news emanating from Japan that can be used by the media to explain the Yen's weakness in a more 'acceptable' way.

The recent currency market action brings to mind the Yogi Berra quote "it's deja vu all over again". Recall that the Yen ground lower throughout most of 1997 and 1998. During that period US Treasury Secretary Bob Rubin reiterated his "strong Dollar policy" at every opportunity while the Japanese monetary authorities eagerly anticipated the export-driven recovery that would come about due to a substantially weaker Yen. Many hedge funds made large leveraged bets against the Yen via the Yen carry trade and month after month this trade proved to be a winner. The problem, as always, occurred when a few players tried to exit their positions. 

Below is a chart showing Yen futures during the 1997-1998 period. Note that the Yen dropped in almost a straight line for 15 months, but all the gains achieved by the Dollar against the Yen were wiped-away in only 6 weeks. In fact, most of the gains evaporated in early-October 1998 when the Yen surged by 20% in the space of only 3 days. This is what happens when a trade becomes over-crowded and a few of the participants try to get out. There simply isn't enough liquidity (in this case, new sellers) to allow the trades to be closed-out profitably or in an orderly manner. In 1998 the catalyst for the collapse of the Yen carry trade was a very small intervention on the part of the Fed and the BOJ designed to 'stabilise' the Yen-Dollar exchange rate (they were worried that the Yen had fallen too far too fast). However, if it hadn't been that it would have been something else. 
 

Below is a chart showing Yen futures from May 2000 to the present. The chart also shows a projection of what we think is likely to happen over the next several months. In our opinion it is inevitable that the Yen will reverse sharply higher at some point during the first half of 2002 in a similar fashion to its 1998 reversal. The catalyst for the reversal may even turn out to be the same (an attempt by central banks to 'stabilise' the market). On the below chart we show the turning point occurring at the end of March primarily because a March-April bottom for the Yen meshes with our views on the US$ and the US stock market. 
 

Although we expect 2002 to be a good year for the Yen (after some weakness during the first quarter), our long-term view remains bearish. We've written periodically over the past 2 years that the BOJ would eventually be forced to inflate at a faster rate than the Fed. A relatively-higher inflation rate is a major negative for a currency unless the country experiencing the higher inflation can figure out a way to export that inflation (as the US has been able to do with great success over the past 5 years).

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