‘Vision without action is a daydream. Action without vision is a nightmare’Japanese proverb (Civilization Quotations by Richard Krieger 2002)
Key Issues – Driven by ever lower interest rates the US$ has endured years of structural weakness, especially against the Japanese Yen.
Key recommendation– this low interest rate environment will not last forever, coupled with increasing bouts of intervention, a base for the dollar is now in sight.
Japan—from all conquering superpower to economic stagnation
The rise from the ashes of WWII was as dramatic as it was fast. Driven by relentless modernisation, lean manufacturing process and the Keiretsuconglomerates, Japan soon overtook all but the US establishing itself as the world’s 2nd largest economy. By the 1980’s this assent seemed to be unstoppable, perhaps forecasting a further march to dominance.
However the bursting of the property and stock market bubbles, lead a full scale retrenchment across Japanese society. In the ensuing decades a virtually zero interest rate policy has prevailed. Slow growth, with low stable interest rates all the way along the curve, have been combined with a steady trade surplus. All these factors have tended to support the appreciation of the currency.
With the Fukushima earthquake still casting a long shadow, will Japan now have the resolve to shake off these woes?
Japanese history – big events have caused profound changes
Two previous events marked big turning points in the country’s path.
When Admiral Perry sailed with the USS Mississippi to Edo in 1853, the ease with which modern American weapons made light of the Japanese defences caused a sea-change in society. Over the next 50 years, the once feudal ways were swept away by a revolution across society.
In a similar way, the defeat in 1945 and the occupation by General MacArthur forced a complete break with the past. In 1951, Japan’s GNP was $14.2 billion, a third of Britain’s. By 1975, Japan had not only overtaken all individual European countries, but GNP was now double that of the UK (Source: Japan Reference).
The causes of the post-war economic miracle are, needless to say, myriad, but it is also fair to say that an aggressive activist industrial policy orchestrated by MITI was part of this process.
What can be done now – a lesson from the Fed?
In fact, it was the Japanese that started the whole process of ‘quantitative easing’. The Americans have watched closely how it was done, with the Federal Reserve Bank of San Francisco publishing a report on its effectiveness. This five-year experiment from 2001‘tended to support the notion of …strengthened financial conditions…and had the impact of reducing the call rate’ (Source: Federal Reserve Bank of San Francisco website).
One is dealing in semantics to try and contrast different crises, but the effectiveness in Japan’s programme has been very much in Ben Bernanke’s mind when weighing up monetary policy.
While no less a public figure than Sarah Palin may have complained that QE is a ‘dangerous experiment‘and wouldn’t ‘magically fix economic problems’, others have explained this ‘was a key factor in taking deflation risk off the table’, for example Peter Hooper, chief economist at Deutsche Bank (Source: Bloomberg.com, 17/3). Moreover, the almost move-by-move recovery in the stock market had helped to boost the wealth effect. While many questions remain about how to exit from what comprises a very large numbers of assets purchased, attention has now been drawn as to whether Japan can go further down this route.
William Pesek notes three possible choices to play for after the recent earthquake induced renewed economic crisis. ‘One, issue loads of debt that may prompt credit downgrades and raise taxes. Two, dump its $886 billion of USdebt, destabilising the biggest economy and enraging a key ally. Three, get the BoJ to monetise public debt’ (Source: Bloomberg.com, 31/3).
Japan has a big decades old problem but a not certain solution
With a New Yorker at the helm, it would not take much imagination to see what would have happened in Tokyo a long time ago. The tried and tested monetary big guns would now be deployed to rest the initiative. Investors would be seeing through the problems and Japanese stocks would be booming. A competitively priced currency would be part of this game plan.
Disasters have galvanised Japan before, so this could be the moment.
Even Fukushima did not changed the dynamics
In a comprehensive article on the readiness of Japanese society to embrace unconventional moves such as aggressive monetary stimulation, Business Week found a more cynical attitude amongst the populace. ‘A quick chat with the man on the Tokyo street is all it takes to understand just how disenchanted many Japanese are’ (Source: Businessweek.com, 17/3). One interviewee, Natsu Hasegawa, commented, ‘there is so much conflicting information, and everything is said with ‘maybe’ and ‘possibly’, nothing specific‘ (Source: Businessweek.com, 17/3).
‘I hold a very serious view of Japan’s economy and its outlook….taking this view into account, the BOJ has conducted powerful monetary easing’ Shirakawa Governor (source CNBC.com 7/11/11.) But this wittering has not translated into a serious policy initiative, nor turned the tide for the malaise.
It is inconceivable that some sort of monetary stimulation will not continue, much like what had been started in the immediate aftermath of the tragedy. But a game changing event that will galvanise both the economy and society similar to what took place in the 1950s and 60s is harder to predict. Likewise the intervention that took place immediately after the earthquake in March, and again sporadically in recent weeks is likely to continue. But will this turn the entire $/Y relationship?
We need to be mindful of the international context of this action, as the worldwide financial crisis has gripped. As Vimal Gor, head of fixed income at BT Investment Management put it ‘ the yen remains one of our favourite currencies as Japan still has a strong trade surplus and benefits from the global risk aversion that we’re seeing. Unilateral interventions in the Japanese currency have no real lasting impact. If anything we’d view this as a buying opportunity’ (source Bloomberg.com 6/11/11.)
The 2011ecomomic crisis may be seen as just one more small step towards decline.
In the middle part of the decade, many investors and speculators used the Yen as part of a carry trade positioning. This can be seen from the above chart (source Bloomberg CFTC statistics.)
This meant that the foreign exchange market was structurally short Yen. In more recent years as the financial crisis has gripped markets, the Yen has been seen as a safe haven. Again, with interest rates now at ultra low levels in most major currency markets, the yield give up has narrowed to make the carry trade less interesting. These two factors have given a net long Yen bias as can be seen in the CFTC figures from 2008 onwards. It can be deduced that these long Japanese Yen positions could lead to a more dramatic turn around when the financial crisis ends.
Interest rates and currencies
Currencies movements have been blamed on all sorts of factors, balance of payments, political risk, absolute levels of growth and many more. But increasingly in the 21st century interest rate differences have played a dominant part in currency pairs. With Japan mired in stagnation, this has never been more true than in
The Yen has seen investment flows due to its safe haven status, but more crucially as the interest rate difference between Japan and others has sharply narrowed. The collapse in US yields has been pronounced with differentials between the two countries now pared back to the bone.
So what now are the prospects for US interest rates?
In the press release that came after the Federal Reserve’s meeting in September ‘ the committee …decided to keep the target range for the federal funds rate at 0 to ¼% … at least through mid-2013’ (source Federal Reserve website.) With this clear statement and with the ever present dual mandate encouraging the Fed to consider employment with its deliberations, this seems to give us an emphatic understanding to interest rates for quite some time.
In April 2011 Ben Bernanke established a new precedent in holding a press conference after the usual FOMC meeting. At this inaugural event, the Fed Chairman gave us some insights into the thinking process on rates. ‘It is not clear that we can get substantial improvements in payrollswithout some additional inflation risks’ (source AOL news 27/4/11.) This effectively seems to endorse a higher inflation rate will be tolerated in the interest of seeing unemployment reduce. With this matrix stubbornly holding around 9% this seems to take off the table any prospective rate rises, indeed as the Fed confirmed at the September meeting.
However, at the same press conference the Chairman made further illuminating remarks ‘in my view we can’t achieve a sustainable recovery without keeping inflation under control.’ Bernanke recognised not just the mandate to control inflation, but why that is so important. High inflation distorts investment and hampers growth. With US CPI well above 3% throughout the summer of 2011 risks are already being taken. Inflation still matters when considering the future prospects for US interest rates.
US economy—not as bad as feared
In the summer months an explosive cocktail of political crisis’s seemed to engulf markets and presage an economic double dip. In the US, the squabble on Capitol Hill about the debt ceiling lasted right up to the wire, while in Europe dominos in Southern Europe continued to fall. The fallout from Japan’s earthquake still seemed to cast a negative impact on the global economy.
However the markets near panic, which reached its nadir in early October, seem to have been overdone. The economic statistics that have come through in the 3rd quarter seemed to show a stable, if slow, level of growth at least in Americaand the UK. At the same time continued strong earnings growth gave equities a boost, and accordingly restored some bid to all asset markets.
Prospects for 2012 remain uncertain but there are grounds for optimism. In this environment the ultra-low interest policy cannot be taken to last forever. Easy money has come at a price as inflation has held at higher levels than forecasted in several Anglo-Saxon countries, while this has been a persistent problem in the emerging world.
Timing is everything—the market will move before the Fed
There is still unlikely to be any sudden pickup in economic activity in the first half of 2012. However, with the economy holding up in a better than expected fashion in 2011, prospects longer term are more positive. The sustained impact of ultra-low interest rates, plus the overall benefits of global demand may see the beginnings of a meaningful advance in the second half of the year.
It is this pickup in activity that should provide us with our trigger point for bond yields. This has historically come about 6-9 months before any movement in official rates.
Our timing expects a step change in growth sometime towards the end of 2012, with the Fed moving perhaps six months later in mid-2013. This will fit with the current policy statement.
Conclusion—Dollar Yen is a game of patience
We are now four years into the financial crisis, and during that period the Yen has been a major beneficiary. Despite historically attractive levels, and periodic intervention there are no immediate trigger points to expect a turnaround.
However as the crisis has matured the US economy has showed surprising resilience in recent months. It is expected that more test lie ahead in the early months of 2012, but the end is now in sight to this cycle. With the Federal Reserve’s implied inflation target rate of 2% dangerously exceeded, policy can begin to be normalised in 2013 and beyond. This gives good prospects for Dollar/Yen, however an ideal entry level is likely to be in the second half of 2012.