What The Strong Yen Means

Currency Strength and Quasi-Depression, Japan-style

As the US dollar weakens, other currencies necessarily increase. The euro is now trading above $1.48 to the dollar, a record high. And the Japanese yen is stronger than 109 to the dollar, a two-year high.

All currency movements proximately reflect differentials in short-term interest rates. The weakness in the dollar over the last two months was caused by the Federal Reserve’s interest-rate cuts in September and October.

Underlying economic fundamentals in each respective currency zone also affect exchange rates, since they have an impact on market interest rates as well as policy interest rates. Speaking very broadly, a lower currency value can reflect concern about the business outlook for a particular country.

This analysis holds reasonably well for the dollar-euro rate. But what’s the story with the Japanese yen?

More.

The domestic Japanese economy is near-comatose and has been for 15 years. You probably remember a lot of unpleasantness about an asset bubble over there, which happened when the Reagan Administration forced Japan to allow the yen to almost double in value against the dollar. (Back in the mid-Eighties, every day had a news story about how the strong dollar was killing US exporters and allowing Japan to steal all of our precious manufacturing jobs.)

To address the economic coma that followed when the bubble popped in the early Nineties, Japan’s government went on a multiyear binge of deficit spending. If you thought we build bridges to nowhere, take a look at some of the insane projects they’ve built in rural Japan. They now have by far the highest national debt in the world, more than twice as high as ours as a percentage of GDP.

Didn’t help. Nothing has helped. Not even real interest rates that are by far the lowest among large economies, and at times have even been negative.

Today, like every major economy in the world except the United States, Japan is suffering the effects of inflation, showing up mostly in commodity and food prices. As in Europe, this makes it hard for the Bank of Japan to lower interest rates, although the BoJ actually would prefer to increase rates from their current 0.50%. (The comparable policy rate in the US, after two cuts, is 4.50%, and the euro rate is 4%.)

As in most Asian countries, Japan’s banking and financial systems are not quite squeaky-clean. The BoJ isn’t as independent as a central bank ought to be, and they regularly come under political pressure to keep interest rates low. This was especially in evidence in the last few months as the country went through one of its periodic political convulsions.

All of this results in an intriguing financial phenomenon called the carry trade. You can think of it as an interest-rate arbitrage. Typically, you go to Japan and borrow a lot of money at their microscopic interest rates. Then you turn around and go to a high-rate country like Australia, New Zealand, South Africa, or Iceland and lend it to the local government or businesses. You put the interest-rate differential in your pocket and life is good, so long as the relative exchange rates remain favorable.

Remember, when you unwind the carry trade, you have to buy yen at the current market rate in order to repay what you borrowed. If the yen has strengthened in the interim, you’re in a lot of trouble.

No problem, there’s such a thing as financial engineering. You simply hedge your currency exposure with derivatives. Ok, that works. Except in times of high market volatility, which makes options much more expensive. And guess what? We’re now in the longest period of extremely high volatility that I can remember.

Bottom line, the carry trade has been less attractive than usual on most days for several months now, and this adds upward pressure to the value of the yen.

So even though the domestic economy in Japan is generally weak (there have been a few signs of strength recently), the bias in the yen is not as weak as it might otherwise have been. Combined with the perfect storm that has been knocking the dollar down, this makes life difficult for Japanese exporters.

In fact, companies like Honda and Sony that earn a majority of their profits in North America have been hit hard. As their earnings have fallen, their stock prices have taken it on the chin.

But how will Japanese companies react to this situation as a whole?

Japan is still a major exporter to China, India, Europe, and elsewhere. One doesn’t normally think of flexibility as a hallmark of Japan’s economy (that’s more a quality you associate with ours). But there are some indications that the Japanese are successfully transitioning their export productivity away from weak US markets and toward stronger markets elsewhere.

The yen’s recent strength puts Japan at a disadvantage exporting to the US (on top of decreased US demand). But this effect is much less pronounced against the euro, which has also been strengthening. And the Chinese yuan has been appreciating just a little bit faster too.*

If the trend is real and it holds up, expect the Japanese to emerge from the current period of US weakness in not particularly bad shape.

I’ll close by asking a question that is something of a stretch. Risk-free interest rates in the US are now extraordinarily low across the yield curve, and in fact they’re going lower. Our rates are still hundreds of basis points higher than Japan’s. But is it at all possible that we are entering a multi-year period of low domestic growth, together with extremely high but easily-sustainable government deficits? In short, a mild form of the economic disease Japan has suffered from for almost two decades? If the Federal Reserve is forced to reverse their current stance and keep cutting US rates, then this case becomes credible.

*Not nearly fast enough, of course. When the yuan was at 7.47 a few weeks back, I predicted in this space that it would strengthen to 7.4 by year-end. It’s now 7.41+.

Unlike the yen-rate story, the yuan story is about international politics. The Chinese will let their currency appreciate just enough to forestall trade war, and not a bit more.