The most compelling explanation of the persistent Japanese yen (JPY) weakness that has so flummoxed European finance ministers and U.S. auto producers in January and February are the low Japanese interest rates and the steepness of the curve, which offers attractive financing and hedging opportunities. But the BOJ’s rate hike in February may prove insufficient to put a solid floor under the yen.
The UK, Sweden, and Norway have already hiked rates this year. The Eurozone, Switzerland, and New Zealand are not far behind. The BOJ rate hike merely stabilizes the shortterm interest-rate differentials where they were at the end of 2006. Indeed, given those prospective rate hikes, the risk is that interest-rate differentials may not have peaked yet.
That said, in the second half of the first quarter and into early Q2, there are a few factors that may stymie the yen bears. First, after the milquetoast G7 statement, net speculative short yen positions at the IMM set new record levels. The yen may strengthen when these positions are adjusted.
But speculators might not be the only source of demand. Ahead of the fiscal year-end at the end of March, Japanese institutional investors typically repatriate funds back home largely for window- dressing purposes. Weekly data from the Ministry of Finance suggests this has already begun. At the same time, foreign appetite for Japanese stocks remains robust.
Policy makers, investors, and journalists have expressed concern about the impact of the unwinding of yen carry trades. Much of the angst appears exaggerated and a function of emphasizing the role of speculators too much. Between late October and early December, the net short yen futures (JY) speculative positions at the Chicago Mercantile Exchange were dramatically cut — by more than 80 percent — from 137,300 contracts (each worth JPY12.5 million) to 23,500. Markets remained orderly. In fact, during this unwinding of short yen positions, the Euro, sterling, Australian dollar, and many other currencies continued to appreciate against the Japanese currency. The dollar itself though fell four to five yen.
One of the reasons for this counterintuitive development is that the yen carry trade appears to be in more stable hands. Japanese investors themselves have been significant sellers of yen and buyers of higher-yielding securities. In the current fiscal year that began in April 2006 through the end of the year, for which monthly data is available, Japanese investors bought more than $75 billion of foreign assets.
These purchases of foreign assets by Japanese investors are a salutary development. It means the private sector is recycling the country’s current account surplus, which in turn means the government does not have to. Indeed, the BOJ has not intervened in the foreign exchange market in three years and its ability to remain on the sidelines is predicated on the private sector recycling the current account surplus.
In turn, the private sector’s appetite for foreign investment is a function of the low returns available at home. The low returns are not just limited to interest rates, but also extend to the return on equity. MSCI calculations estimate the average return on equity of Japanese companies is 8 to 9 percent, compared with the mid-teens for European companies and high teens for U.S. companies.
It appears the opportunity to normalize Japan’s monetary policy in this cycle has already passed. Although the Japanese economy is enjoying its longest expansion in modern times, price pressures remain practically nonexistent. The GDP deflator is still negative (-0.5 percent in Q4 2006). With the fall in energy prices, producer prices likely have peaked. The BOJ forecasts less of a rise in 2007 than in 2006. Consumer prices also appear to be peaking just above zero.
Fiscal policy has not been normalized, either. Despite the sustained economic upswing, the budget deficit is still in excess of 4 percent of GDP. The decline in Prime Minister Shinzo Abe’s support rating and his lack of a popular mandate in the first place may have deterred much of a discussion of fiscal policy. However, the focus is likely to shift from monetary policy to tax hikes to close the budget gap.
It is also not clear that consumption, which accounts for 55 percent of Japan’s GDP, will offer much support for the economy. The strong showing in Q4 2006 (1.2 percent) needs to be partly understood as payback for the 0.4 percent decline in the previous quarter. Since 2000, consumption has risen by a quarterly average of 0.33 percent. The quarterly average for the past two years is nearly twice as high, but still remains paltry at 0.62 percent.
Wages rose 0.2 percent last year after falling 10 percent between 1997 and 2005. To the extent that the weak wage gains limit potential consumption, investors are advised to pay attention to monthly compensation figures the government publishes with the monthly labor market report. However, while stronger wage increases are necessary, it might not boost consumption. In recent years, household savings have been drawn down, partly to sustain consumption levels.
These considerations suggest the yen’s recovery in the second half of Q1 is unlikely to be sustained. Using the recent past as a rough guide, the U.S. dollar could fall five to six yen from its peak above JPY 122.00. Such a pullback would bring the 200-day moving average, now near 117.00, into play. A band of technical support extends toward 115.00. In terms of time and levels, this may correspond to the deployment of Japanese investment capital overseas early in the new fiscal year.
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