Why Japan's Yen Move Backfired
03/22/2011 7:00 am EST
How did the value of the yen reach new highs at the same time the risk of Japan defaulting on mountains of debt soared? The answer to that shows why Japan still needs to buy plenty of US debt.
An earthquake and tsunami devastate Japan, the country hangs on the edge of a nuclear disaster...and the yen soars to a post-World War II high of 76.25 against the dollar.
An earthquake and tsunami devastate Japan, 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 could be headed to a meltdown, followed by a market reversal just days later—with stocks rallying on hopes that the meltdown could be averted—seems completely understandable in comparison. Sell-off-to-rally is just normal stock market yo-yoing when nobody has enough information for a rational decision.
But this other stuff—the strongest postwar yen and simultaneously the greatest danger ever that Japan's government would default—that's just nuts, right?
It may be perverse, but it's perversely logical. And if you can wrap your mind around why it makes sense for the yen to rally, even as Japan's government debt gets dissed, you might have a chance of figuring out whether Japan's need to go hundreds of billions of dollars further in debt to finance a post-tsunami reconstruction is going to be good or bad for the bonds of the deeply indebted United States.
OK, Are Your Seat Belts Tight?
Let's go for a bumpy ride in the global financial markets.
The Bank of Japan responded to the disaster immediately, flooding the financial system with yen. On March 13, Masaaki Shirakawa, the Bank of Japan's governor, 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 single-day cash infusion.
That same day, March 14, the bank doubled the size of its asset-purchase fund to 10 trillion yen ($120 billion or thereabouts) 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 a third the size of the US economy.
As the crisis unfolded, the Bank of Japan continued to inject even more yen into the economy.
Currency traders saw opportunity in this massive injection of yen into the financial markets. Already-low Japanese interest rates might not get any lower—zero is zero, after all—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, for example. (This is called the yen carry trade.)
That is exactly what traders did, creating demand for the yen despite the disaster and the huge increase in Japan's currency supply.
Hence a soaring yen, and one where trade threatened to take on an irresistible momentum. A currency that is predictably headed in one direction is an open invitation for investors to jump on.
NEXT: Another Disaster for Japan|pagebreak|
Soaring Yen Another Disaster for Japan
The appreciating yen created a huge problem for the Bank of Japan. At the post-WWII high of 76 yen to the dollar, Japanese exporters couldn't make any money.
For example, Honda Motor (HMC) estimates that it loses 17 billion yen in earnings for each one-yen appreciation in the currency against the US dollar. So the infusion of yen, designed to stabilize Japan's financial system and save its economy, instead threatened to wreck that economy.
At this juncture, the Bank of Japan called on the Group of Seven industrialized economies for help. The result was the first coordinated currency intervention by the G7 since 2000, as first the Bank of Japan, then European central banks, then the US Federal Reserve sold yen in a successful effort to stop the currency's appreciation.
Does the Bank of Japan Have Enough Firepower?
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 the intervention at that level was one reason for the strong recovery in Japanese stocks at the end of last 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 under way.
And for the days ahead, you can expect more attacks on this level in tests of the resolve—and firepower—of the world's central banks. And especially of the strength 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 over the long term.
Deutsche Bank told Bloomberg that it calculates 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 gross domestic product to the country's debt load, already the highest in the world as a percentage of GDP.
With Japan 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. Profits are what count, while limiting risk to levels that traders think are reasonable.
There's a limit to how far anyone who borrowed yen would like to see the currency appreciate. 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 yen that have grown more expensive.
And just as importantly, currency traders and carry-trade investors know that at some point, buyers of Japanese government debt—even the domestic 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.
What Does This Mean for US Debt?
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 US Treasuries, and certainty it would be reasonable to expect that Japan's need for so much capital at home would lead to selling US 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 it continues to pile up.
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 be, perversely, to increase the need for balancing diversification in fixed-income portfolios. And while no one may like US dollar-denominated assets, there is currently no alternative to the liquidity of the US Treasury market if you are an investor looking to balance new holdings of Japanese debt.
In the short run, Japan's need to issue much more debt could actually increase the demand for US Treasury debt.
In the long run, and even probably in the medium run, this situation is neither healthy nor stable. No global investor is going to be happy with a portfolio overweighted 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 of them, if not both.
Whatever perverse logic rules the shorter term, over the longer term I think the tide toward credit upgrades in developing countries (and credit downgrades in developed economies) will run stronger and faster in the wake of Japan's disaster. 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 longer term will arrive.
The bottom line for US investors: Even as the yen fluctuates wildly, and the US remains dependent on having lots of foreign buyers of its debt, you don't need to worry near-term about significantly rising interest rates.
It's the long-term outlook I worry about—and will be keeping a close eye on.
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 (JUBAX), 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 here.