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Why the yen hit new highs while Japan was near meltdown and other perversities of the financial markets
03/21/2011 8:30 am EST
An earthquake and tsunami devastate Japan and the country hangs on the edge of a nuclear disaster, and the cost of insuring against a default on Japan’s government debt in the credit-default swaps market rises to an all time high.
Seems perverse, no? The sell off in the stock market on fears that one or more Japanese reactors was headed to a meltdown and then the reversal just days later when stocks rallied on hopes that the meltdown could be averted seems completely understandable in comparison. Sell-off to rally is just the normal stock market yo-yoing when nobody has enough information for a rational decision.
But this other stuff—strongest yen since WWII and simultaneously the greatest danger ever that Japan’s government would default—that’s just nuts, right?
No, perverse it may be but it’s perversely logical. And if you can get your mind wrapped around why it makes sense for the yen to rally while Japan’s governmental debt gets dissed, then you might have a chance of figuring out whether Japan’s need to go hundreds of billions of dollar further into debt in order to finance a post-tsunami reconstruction is going to be good or bad for the bonds of the deeply indebted United States.
Okay, seat belts tight? Let’s go for a bumpy ride in the global financial markets.
The Bank of Japan immediately responded to the disaster by flooding the financial system with yen. On March 13 Bank of Japan governor Masaaki Shirakawa said he was prepared to unleash “massive” liquidity. And Shirakawa meant it. The next day the bank injected 15 trillion yen (roughly $175 billion) in one-day cash, a record for a one-day cash infusion. That same day, March 14, the bank doubled the size of its asset-purchase fund to 10 trillion yen ($120 billion, roughly) so it could buy more government debt and other securities. (When a central bank buys debt, it puts more money into the economy. And, to get a full sense of the impact of these moves on the Japanese economy, remember that the Japanese economy is roughly one-third the size of the U.S. economy.) As the disaster unfolded, the Bank of Japan continued to inject more yen into the economy.
Currency traders saw opportunity in this massive injection of trillions of yen into the financial markets. Already low Japanese interest rates might not get any lower—zero is zero—but they sure weren’t going up either. And that made it cheap and safe to borrow yen and then use that cash to buy assets with higher yields—Australian dollar bonds or German bund. (This is called the yen carry trade.) Which is exactly what traders did, creating, in spite of the disaster and the huge increase in the supply of yen, a demand for the Japanese currency.
Hence, a soaring yen, and one where the trade threatened to take on an irresistible momentum. Whether you were involved in the carry trade, a currency that is predictably headed in one direction or the other is just an invitation to jumping on.
The appreciating yen had created a huge problem for the Bank of Japan. At that post-World War II high of 76 yen to the dollar, Japanese exporters couldn’t make any money. For example, Honda Motor estimates that it loses 17 billion yen in earnings for each one yen appreciation in the currency against the U.S. dollar. The infusion of yen designed to stabilize the financial system and save the economy threaten to wreck the economy.
At this juncture the Bank of Japan called on the G-7 economies for help. The result was the first coordinated currency intervention by the G-7 since 2000 as first the Bank of Japan, then European central banks, and then U.S. Federal Reserve sold yen in a successful effort to stop the yen’s appreciation.
The goal is to put a floor under the yen at 82 to the dollar, a level widely seen as the difference between profit and loss for many of Japan’s big exporters. (The success of intervention at that level was one reason for the strong recovery in Japanese stocks at the end of the week.)
But the battle to hold the line at 82 is by no means over. Currency traders certainly know that the Japanese government is going to flood the market with more yen as recovery spending gets underway. And for the week ahead, you can expect more attacks on this level in tests of the resolve—and fire power—of the world’s central banks.
And especially of the fire power of the Bank of Japan.
This is where the short-term story of the currency markets meets the medium-term story of Japan’s already huge debt load. Currency traders doubt that the Bank of Japan and the Japanese government have the cash to keep the yen from rising in the long-term. Deutsche Bank told Bloomberg that it calculates that it would cost $500 billion to intervene at roughly the scale of the bank’s last efforts to weaken the yen. That’s equal to adding 10% of Japan’s GDP to the country’s debt load, already the highest in the world as a percentage of GDP. With the country already looking at huge increases in borrowing to fund a recovery effort that’s more than the Bank of Japan is probably willing to commit.
Remember, though that the goal of traders in these markets isn’t to score some magic exchange rate victory. It’s profits that count. And limiting risk to levels that traders think reasonable. There’s a limit to how far anyone who borrowed yen would like to see the currency appreciate, since no one wants to see all the profits from using yen to buy higher yielding assets disappear thanks to a need to pay off those loans with more expensive yen.
And just as importantly currency traders and carry-trade investors know that at some point buyers of Japanese government debt—even the domestic Japanese buyers of that debt—will balk at buying more. No one knows where that point is but no trader wants to run an experiment with a real money portfolio to find out. Fear of that moment will eventually reverse the current direction of the yen.
And how will all of this affect the debt of the world’s other great borrower, the United States? The Japanese are among the world’s big owners of U.S. Treasuries, and certainty it would be only reasonable to expect that Japan’s need for so much capital at home would lead to selling to U.S. Treasuries and the repatriation of that capital.
I think that’s a reasonable long-term worry. (But then I think any reasonable person should be worried about where the United States will find buyers for all the new debt that it continues to pile up.)
But in the shorter run, “reasonable logic” will take a back seat to “perverse logic.” One effect of Japan’s need to issue huge amounts of additional debt will, perversely, be to increase the need for balancing diversification in fixed income portfolios. And while no one may like U.S. dollar-denominated assets, in the short-run there is really no current alternative to the liquidity of the U.S. Treasury market if you are an investor looking to balance new holdings of Japanese debt.
In the short-run Japan’s need to issue lots more debt could actually increase the demand for U.S. Treasury debt.
In the long run, even probably in the medium-run, this situation isn’t either healthy or stable. No global investor is going to be happy with a portfolio over-weighted to the slow growth economies of these two developed nations. Especially since the most likely long-term forecasts point to depreciating currencies and rising interest rates in at least one, if not both, of these economies.
In the longer-term, whatever the perverse logic of the shorter-term, I think the tide toward credit upgrades in developing countries (and credit downgrades in developed economies) will run stronger and faster after the disaster in Japan.
And the push to increase the liquidity of assets not denominated in yen, euros or dollars just got a little more insistent.
It’s just a question of when that long-term might arrive.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of January see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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