No Yen for the Yen

Focus: Currencies

Axel Merk Image Axel Merk President and Chief Investment Officer, Merk Investments, LLC

Japan's currency has been an odd source of strength for many years, but its island of stability is eroding, warns Axel Merk of Merk Insights.

Because of Japan’s massive public debt burden, pundits have called for the demise of the Japanese yen for years. Are the yen’s fortunes finally changing?

Our analysis shows that the days of the yen being perceived as a safe haven may soon be over. Let us elaborate.

So many foreign-exchange speculators have lost money shorting the yen that the currency earned the nickname the "widow maker." Indeed, as the yen has had a weak patch as of late, some are already cautioning the trade might be crowded. But we don’t talk about a trade; we talk about a fundamental shift in the dynamics that might finally be unfolding.

To understand the yen, consider the earthquakes that hit New Zealand and Japan in early 2011. New Zealand’s shaker caused the New Zealand dollar to fall; Japan’s earthquake, in contrast, pushed the yen higher. In the short-term, earthquakes disrupt economic growth; conventional wisdom suggests less growth leads to a weaker currency. However, economic growth and currencies do not correlate as highly as one might expect.

Indeed, everything appears backwards in Japan, and there’s a reason: historically, Japan has enjoyed a current account surplus. As a result, Japan does not rely on inflows from abroad to finance its budget deficit. Despite conventional wisdom, note that when there’s a shock to the economy, consumers save more and spend less, a positive to a currency all else being equal (i.e., in the absence of a current account deficit).

In contrast, countries like the United States, or New Zealand for that matter, have a current account deficit; in the absence of growth, foreigners are less inclined to invest in the country, potentially depriving the country of inflows needed to finance budget deficits, in the process, putting downward pressure on the currency.