Uncertain times

This line of reasoning — the parallels between Japan in the 1990s and the U.S. in 2007-2008 — is very much on the minds of some traders, including Japanese traders. Uncertainty is unbearably high. If conventional wisdom is right and the U.S. is going into an inflationary period, the forex market will punish the dollar with relentless selling. This means the carry trade may be okay for some other currency pair, but not dollar/yen. The yen will rise alongside everything else.

On the other hand, the U.S. may be going into a deflationary period. Recession and deflation imply a lot less demand for Japanese goods in the U.S. — and more importantly, demand for Japanese capital goods (like machinery) in the emerging market suppliers to the U.S. like China, Japan’s biggest overseas customer. Thus, the yen should fall as economic growth subsides from the recent robust 4 percent level to 1-2 percent. Japan will not only remain deflationary, it will become more so, and the legacy of January 1990 will live on. Such an outcome is yen-negative.

It shows the dollar/yen from 1998 to today, with a linear regression channel starting in the middle of the Long-Term Capital crisis of 1998. It also has four big “cycle” lines superimposed. Today the dollar/yen is right in the center of a horizontal linear regression trendline. Yes, we cheated in selecting the starting point of the channel, but it was to illustrate the point that having retraced some 65 percent of the previous move, the yen could now be headed upward, back toward the channel top near 100. The critical level is the mid-2006 spike at 109 (circle). As we all know, once the price convincingly surpasses a previous high, it’s a breakout and trend-followers should get on board.

We think the inflation argument has more weight than the deflation argument, but the recent tendency of the yen to rise against the dollar is bothersome. The conclusion: you can no longer sell the yen against everything on raw interest rate differentials. You may be able to sell it against stable high-yielders like the Australian dollar, but not the dollar and pound, since Britain has a housing bubble that may be bursting, too. And if Fed and Bank of England central bankers take Mishkin’s advice, they will be throwing money out of helicopters — i.e., cutting rates — for many months to come.