The Yen Rising

The yen had been rising from ¥201 to the dollar at yearend 1985, consistent with high and rising current account surpluses. It peaked at 122 in November 1988. But throughout the course of 1989, the yen steadily weakened to 158.20 by April of 1990. There were good reasons to shun the yen. The Japanese banking system was coming apart at the seams, with banks failing left and right and corporate bankruptcies in the thousands every month.

The government had emergency spending plans in place to try to goose the recessionary economy, but the economy didn’t respond.

This is when we heard Keynes being cited, as in, “You can’t push on string.” It was as close to a 1930s-style Depression as any country has come since. The Nikkei had already started falling in 1989 from over 40,000 to an intermediate low of 13,019 in October 1998 (it didn’t bottom until 2003). Everyone complained about the weakening yen, including the U.S.

During this period, the S&P swooned from a peak of 1,190 in July 1998 to 923 in October 1998 — 2 percent more than the proverbial 20 percent required to call a down move a “bear market.” The carry trade existed then, too. The Japanese Ministry of Finance, aided by the U.S. Treasury, intervened to drive the yen back up.

This was, in fact, the last time the Japanese intervened to raise the value of the yen. (The subsequent intervention, in 2003 and Q1 2004, which was the biggest ever by any central bank, was to drive it down. The amount then was a combined ¥35.2 trillion.)

In 1997-98, the world financial crisis was triggered by excess liquidity, asset bubbles, and undervalued currencies in emerging markets. Starting in Thailand and moving around the world to other emerging markets such as Brazil and Russia, asset prices fell through the floor. The culmination of the crisis was the failure of the hedge fund Long-Term Capital Management and its Fed-sponsored bailout.

The collapse of the yen carry trade was an accidental byproduct of all this. It started when one fund, Julian Robertson’s Tiger Management, blew up in early October 1998 . The yen rose from 135.64 on Oct. 5, 1998 to 114.32 on Oct. 19 — a net change of almost 22 points in 14 days. Every day the yen moved up several big figures as additional carry traders exited. The BIS is afraid of a replay of this debacle, even though in 1998 the yen was simply an innocent bystander.

The BIS report also mentions the possibility of another global meltdown arising from the U.S. sub-prime mortgage problem, which has so far caused grief and gnashing of teeth at Bear Stearns and the failure or takeover of some 60 lesser mortgage providers — but no big-institution failures and (so far) no domino effect. The point (for the forex market) is not whether the U.S. sub-prime market is going to crash, but whether it inspires fresh risk aversion. Overall, general risk aversion is assumed to include aversion to the yen carry trade.

It remains to be seen whether that is a valid assumption. No one disputes that risk aversion is too low. The JP Morgan index of emerging market bonds showed a 14-percent spread over Treasuries in 1999, and was at 1.56 percent on June 26.

Perhaps in 1999 traders were overly risk-averse, but 1.56 percent sounds too low. The Japanese Ministry of Finance is taking an unusually aggressive stance with its policy switch. At a guess, it doesn’t want to be blamed for a replay of 1998 now that the BIS, International Monetary Fund, and many other authorities are pointing a finger at it.

In fact, with deflationary conditions still in place in Japan despite good growth, it is perhaps taking a noble risk for the good of the world rather than its own immediate self-interest. Notice that the Bank of Japan (BOJ) is being left out of things so far.

The obvious solution to the wide yield differential is to raise interest rates. Technically the BOJ is independent and can resist government pleas for higher rates, which leaves intervention (verbal or cash) the only tool at Japan’s disposal.

We should probably assume that Japan wants to avert a world crisis by inching the yen up instead of having hedge funds exit the carry trade in a panic, causing a move similar to the 1998 rush for the exits.

A more gradual dollar drop/yen rise — a 45-degree slope rather than a 90- degree one — puts the yen at the desired level around ¥101 two years from now, in June 2009. But as we all know, this is not how markets work. They work in a far choppier and violent way.

If this policy change is the real deal, the Japanese (and presumably others) are going to have to intervene most judiciously — after all, the yield advantage still exists. The big question is whether there is a big firm out there like Robertson’s Tiger Fund that will take away their latitude of action and jump the gun on carry-trade unwinding.

An equally big problem is if the yen starts rising, the dollar will be on the ropes against everything. We will hear again about all those tiresome pseudo-issues such as the current account deficit and reserve diversification. Still, a rise in the yen is a fall in the dollar, whatever it means. The market has more money than the Bank of Japan, even if combined with other central banks.

We should not expect a sharp rise in the yen anytime soon. But the risk of a yen short position — with the trend and with the logic of yield differentials — is now much, much higher.