A yen for destruction

None of this explains why the dollar, Euro, and British pound are crashing against the yen. This doesn’t make sense in terms of the economic outlook. Japan has already announced the worst GDP numbers out of all of the G7 — a 12-percent drop year-over year in Q4 2008. Japanese inflation is practically zero, along with its interest rate, meaning that capital is not flowing to Japan for a better real yield. The Nikkei stock index has fallen as much or more than other national indices, and foreigners are hardly rushing into Japanese stocks to take advantage of a rising currency. A reversal of the carry trade is the only explanation for the rising yen, but it’s difficult to get hard data on this. Spot and forward trades are the private business of the bank or broker and customer. We can only deduce that longer-term carry trades started being unwound late last summer and are still being unwound today. The biggest carry trade was the Australian dollar/Japanese yen. This is what “falling off the cliff” looks like.

Whatever the cause, the Japanese yen is the unwilling victim of market driven competitive devaluation among the majors. This is in addition to market-driven and state-driven devaluation by emerging-market countries (such as Indonesia and China), and some Asian Tigers (South Korea and Taiwan). Japan just can’t get a break when it comes to the yen.

Now we want to know whether Japan will fight back. Realistically, it has only one policy option — intervention. Former Ministry of Finance official Eisuke Sakakibara continues to voice his view that Japan is simply biding its time. The U.S. election cycle left the country with a lame-duck Treasury secretary until late January, and the new Treasury secretary needs time to find his feet. Was there ever a more respectful and polite manner in international affairs?

Then, the G7 meets in Rome Feb. 13-14. Virtually all of the talks are conducted ahead of time and the communiqué is written beforehand, so talks between the U.S. and Japan on the unjust appreciation of the yen are already in the works. If Mr. Sakakibara is right, Japan will seek approval from the U.S. to intervene, if not an agreement for outright joint intervention. As everyone knows, the announcement effect is very big,especially if it is incorporated in the G7 communiqué itself. It might, however, be enough for Japanese and U.S. officials to hint strongly on the sidelines.

Those who expect the dollar/yen to match the 1995 levels — under 80 yen per dollar — are almost certainly going to be disappointed. We will soon start seeing higher volatility in the dollar/ yen and yen crosses as market players get nervous — very nervous.

The other intervention we expect is in gold. As noted above, gold becomes a popular safe-haven when currencies are being devalued, whether directly by governments or by the market. But governments are familiar with the Hoover comment to Roosevelt. A too high price for gold that is reached too fast scares governments, which have stocks of gold they can release into the market. Should the price of gold approach the March 2008 record high of $1,030.80, we should probably expect some quiet government intervention. And remember, gold is not money, no matter how much the gold bugs insist it is. It may be a store of value, but it is not a medium of exchange. Just try paying for a quart of milk or a gallon of gas with gold. (It’s not even an acceptable unit of account. No country’s authority would accept physical gold for a tax payment.)

Interventions, whether by the Swiss National Bank to drive down the Swiss franc, the Japanese to drive down the yen, or governments driving down the price of gold, are seldom successful. The last big intervention by the Bank of Japan in 2003 and early 2004 was partly successful but hugely expensive — about $400 billion. We need institutional change (whether bank nationalization or other measures) on a vast scale, not market interventions.

But we’ll probably get an intervention anyway, however inefficient. This will make the forex market choppy. Option traders, rejoice. Direction traders, be careful.