The Hammer And The Yen

The Japanese like to say the nail poking out gets hammered back in. The yen currently is poking out and the market may be about to hammer it.

In this context, that means buying it and raising its price vs. the other major currencies, especially the current victims of the yen carry-trade — the New Zealand (NZD) and Australian dollars (AUD), the British pound (GBP), the euro (EUR), and the U.S. dollar (USD).

Many foreign exchange market themes come together in today’s yen situation. The first is a potentially high-risk environment. No one knows for sure whether a Japanese monetary policy change and an unwinding of carry trades is going to force a trend reversal; however, the probability of a reversal is rising.

It’s a mistake to take a position on this probability too early. High-risk situations sometimes evolve slowly and sometimes they deliver shocks. If you are positioned early and wrong, a shock can ruin you.

Governments strive to avoid shocks, but the yen is a perfect case of one of the rules of forex: The institutional factor outweighs all the economic and technical factors. Once a government takes a stand, market behavior flows from that. Sometimes the market immediately capitulates to the stated policy and other times it fights back; regardless, the policy is the topmost consideration.

On June 26 a policy change by the Japanese Ministry of Finance was revealed. It came in the form of a story in the normally staid Nihon Keizai Shimbun newspaper, which flatly reported the government no longer sees a weak yen as acceptable:

“Growing concern over the weak yen has caused Japanese monetary authorities to quietly shift their stance on yen-dollar rates to being ‘watchful,’ after long deeming them as ‘acceptable.’ The change in policy indicates that the Ministry of Finance is not only concerned about mounting pressure from foreign countries to strengthen the yen, but is also worried that further weakness in the currency may reduce Japan’s global competitiveness. In mid-June, senior Finance Ministry officials, including Hiroshi Watanabe, vice finance minister for international affairs, and Naoyuki Shinohara, deputy director- general of the ministry’s International Bureau, discussed how to respond to the yen’s depreciation, and concluded that ‘a further fall in the yen’s value is not desirable’.’”

The reference to reduced competitiveness has to do with the higher cost of imported materials, which hits small and medium-sized businesses the hardest, as well as the weak yen repelling international investors. Trying to make Tokyo a major financial center, competitive with New York and London, is futile. Aformer Ministry of Finance official says, “Only those countries with strong currencies are in a position to attract money and financial institutions from the rest of the world.”

In other words, a “winner” economy has to have more than robust exports. In mid-June, top Ministry of Finance officials decided “a further fall in the yen’s value is not desirable.” In line with that view, the ministry revised a speech on forex rates being prepared for Finance Minister Koji Omi by adding the phrase, “We will keep a watchful eye on foreign exchange rates” to the assertion that “Foreign exchange markets should reflect Japan’s economic fundamentals.” The phrasing was noticed at the time but virtually no one interpreted it as a policy shift.

Now they are trumpeting the change from the rooftops. As we all know by now, the yen has been weak because of the carry trade, which is surrounded by a certain amount of confusion. In its textbook form, a carry-trade consists of the investor borrowing a sum of money in one currency in a low-interest-rate country, converting the sum to another currency and investing the proceeds in a higher-yielding security in that currency.

Logically, we would see a rise in borrowing by foreigners in Japan, a rise in spot trading volume with the higher yielding currencies, and a corresponding rise in investment in the higher-interest-rate countries. In practice, it’s impossible to track any of this from published data. There’s little apparent borrowing by foreigners at Japanese banks and we don’t know the volume of spot forex because it’s the private business of the two counterparties.

As for foreign investment in higher-yielding countries, even in the U.S. we can’t tell whether a rise in foreign investment in CDs or bonds is from a legitimate investor, such as a pension fund, or a speculator, such as a carry trader.

In fact, the vast majority of carry trades entail no actual bank borrowing at all. The carry-trade speculator uses his line of credit at a bank, Japanese or otherwise, to sell yen and simultaneously buy a high-yielding currency. While technically this forex trade is a use of credit, it’s a contingency from an accounting point of view and thus an off-balance- sheet entry.

The “lending” bank makes no money on the transaction, either, except the tiny bid-offer spread when it sells the yen. This is the main reason nobody knows the size of the yen carry trade. Various estimates float around from time to time. At the high end it’s hundreds of billions — possibly more than $1 trillion. In May, a top Japanese official said the carry trade was being exaggerated and it was probably only a few hundred million.

(This official, by the way, was also a proponent of a weak yen since a weak yen promotes exports.) On June 26, the Ministry of Finance announced the yen policy change and this official was reported to be leaving his job as Vice Finance Minister for International Affairs, the agency responsible for the yen in that it determines when and how to use the Bank of Japan to intervene, for example. Is the departure of this official symbolic? Maybe, although he had been in the job about the usual amount of time (three years) and the end of June is the usual time for bureaucrats to play musical chairs in Japan. We may never know.

Just about the only authentic yen carry trade is retail investment flows out of Japan to higher yielding countries, and even that is not a carry trade per se, since the funds represent savings, not borrowings. The size of such outflows is huge and growing. Mutual funds investing in foreign securities are adding thousands of accounts and several hundred million dollars each month.

In April and May alone the Japanese bought foreign bonds (¥1.96 trillion, or about $16.1 billion) and foreign stocks (¥247.1 billion or $20.3 million) in large quantities. This is no surprise since savings accounts and bonds in Japan yield less than 2 percent vs. much higher returns abroad. The Japanese policy change has been a long time coming.

Everybody and his brother has complained about the too-weak yen, from the German Vice Finance Minister ahead of the February G8 meeting to former Fed Chairman Alan Greenspan. The most recent complaint came only one day before the Japanese newspaper announcement from the Bank for International Settlements (BIS) annual report, which stated the weak yen is “not consistent with the Japanese current account position” (a huge surplus). The BIS is worried about a replay of October 1998.