The yen stands alone

It is fair to note, as the Japanese themselves do, that Japan is one of the more group-oriented societies in the world. An old Japanese proverb warns, “The nail that sticks up will be hammered down.” How odd, then, that the Japanese yen — 13.6 percent of the benchmark dollar index (DXY) — is a currency with its own rhythm. It truly marches to the beat of a different drummer.

To an extent casual observers have difficulty believing, most currencies are more or less disconnected from their country’s external trade balance (see “What Drives the Dollar Index?” Currency Trader, January 2006).

Instead, they tend to rise and fall as a function of interest-rate differentials, yield-curve shapes, and returns on assets denominated in that currency. Japan and the yen (JPY) are an exception for several reasons. First, Japan has a virtually permanent trade surplus with the world as a whole and the U.S. in particular. This means importers of Japanese goods must buy JPY to settle their purchases, regardless of the return on holding yen.

Second, as we shall see in detail, Japan’s long experience with deflation and its failed attempts to resuscitate its economy with near zero-percent nominal interest rates made normal covered interest arbitrage impossible and produced some odd effects in the market.

Third, while all governments have meddled in foreign exchange markets, none have meddled as blatantly as Japan. The country rightfully fears its export markets are going to be captured in large measure by other Asian exporters; China in particular.

Fourth, Japan reacted to trade protectionism in the U.S. and elsewhere with a combination of bloated public works expenditures designed (in vain) to increase consumption, occasional policies favoring a strong yen, and direct investment in customer countries (e.g., the automobiles formerly exported from Yokohama are now made in Tennessee and Ohio).

Finally, even as currencies worldwide and the DXY are increasingly linked to both the long end of their respective national yield curves and stock index performance, the JPY appears unrelated to either of these capital market considerations.