But a real problem with going long the yen is that it’s difficult to understand the reasons behind the currency’s rise. Typically, when a trend reversal occurs you can identify the sentiment shift as it is occurring and know what’s coming at least a few days in advance. This time there’s a full plate of “reasons” for the reversal, but none of them are compelling. Even taken as a whole they are not particularly powerful. Besides, the countervailing reasons for the yen to remain in its primary downtrend have not gone away.
Let’s look at the reasons we can comfort ourselves with as we buy yen. First, there was a serious policy shift at the Japanese Ministry of Finance in late June (see “The hammer and the yen”). The government simply no longer sees a weak yen as acceptable. Not only is the government worried about pressure from other countries, notably France, but a weak yen makes energy and commodities expensive in yen terms, which is a negative for small and medium-sized firms, including many exporters. Sony, Honda, and the other big names are experienced hedgers (and cost-cutters), but smaller firms suffer.
It’s wise to respect a stated policy shift such as this because governments can be powerful influences,althoughwe hardly ever see the influence atwork. It’s done behind the scenesusing what is euphemistically called “moral suasion.” In a phone call, over drinks, or at the golf course, an official makes a gentle suggestion to a banker or broker, (“…and Bob’s your uncle”), and the disliked behavior stops instantly. Governments regulate banks and brokers, plus they tax everybody. You disobey a government official’s suggestion at your peril. And in Japan, respect for authority runs high.
There are numerous ways the government could nudge institutions away from a weaker yen. Japanese retail investors are avidly pursuing accounts denominated in other currencies, for example, but that would tend not to be the focus. Instead, attention would likely turn to cutting lines of credit to speculators, chiefly hedge funds, especially if they invested in U.S. sub-prime paper. This would kill two birds with one stone — halting an outflow from yen and reducing exposure to high-risk paper.
The sub-prime housing problem in the U.S. has already hit a number of hedge funds, the main players in the carry trade. An Australian hedge fund hired Blackstone to advise it on subprime investments, and immediately everyone suspects these investments were made with borrowed yen. We don’t know that for a fact, but the mere suspicion suffices to goad some traders into imagining that if there is one firm doing this, there might be dozens.
As far as we know, no hedge fund using borrowed yen to invest in U.S. sub-prime has actually gone under, and we do not know if the sub-prime problem is going to contaminate other collateralized debt funds to the point of failure. But from the hysteria in the blogosphere, you’d think widespread institutional failure is imminent. Nearly all hedge funds are non- Japanese, but if Japanese banks are providing the funding, they are at risk, too.
Japan has no intention of letting its banks fall victim to dud loans to such institutions — or forex trades, either. Presumably, lending to hedge funds has been curtailed, along with credit lines for simple position- aking trading. As for lending to domestic Japanese funds, Japan’s nine biggest banking groups have more than ¥1 trillion ($8.3 billion) in various instruments backed by U.S. sub-prime mortgages, according to the JiJi newswire.
In late July, Financial Services Agency (FSA) chief Yuji Yamamoto told the press the government is closely monitoring Japanese financial institution risk-management practices. The FSA finds the banks “well-prepared.” Considering the entire banking sector was in the tank only 10 years ago and survived only with massive government bailouts, we wonder whether this can be true, but never mind. We should probably assume that Yamamoto told the banks to stop investing in the sector and perhaps even to dump some of the paper. Such trades are, in effect, repatriation, and automatically entail buying yen.
This presupposes the Japanese institutions do not just switch to betterquality foreign paper. After all, the yield differential is still vastly in the favor of the Australian dollar, New Zealand dollar, British pound, euro, and U.S. dollar. If the Japanese government were asking its financial institutions to forego that additional yield, it would be a shocking interference with private business. (That doesn’t mean they wouldn’t do it.)
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