JAPAN GETS SERIOUS ON YEN STRENGTH
BRIAN DOLAN
CHIEF CURRENCY STRATEGIST, FOREX.COM
AFTER months of confusing rhetoric over currency policy, the new Democratic Party of Japan (DPJ) government led by Yukio Hatoyama appears to have finally got serious over combating yen strength.
Japanese investor and corporate sentiment have been pummelled by daily gains in the yen, which have undercut exporters’ profits and caused the Nikkei to seriously lag the global rebound in equities (see chart below). Since the beginning of September, the Nikkei 225 index has diverged markedly from other major stock indices, falling around 13 per cent by the end of November. In contrast the S&P 500 has risen nearly 6.5 per cent and the FTSE 100 has gained nearly 8 per cent.
The sudden surge in the yen following word of Dubai World’s debt troubles appears to have been the final straw, with Hatoyama saying last week that the current strength of the yen can’t be tolerated. The result has been a quick 4 per cent drop against the dollar following Dubai and closer to 5 per cent against sterling.
But there’s more here than simple government rhetoric. Apparently at the government’s urging, the Bank of Japan (BoJ) last week announced it was going to provide ¥10 trillion (£68.5bn) of additional liquidity to banks to spur lending to corporations and consumers.
The BoJ was not dragged kicking and screaming, but rather appears to have belatedly recognised that yen strength was rekindling deflation and threatened to short-circuit Japan’s nascent recovery. Additionally, corporate and consumer sentiment were flagging as stocks sank on yen strength, further undercutting any hopes for a sustainable rebound. The most recent reports suggest that the central bank or the Japanese government may expand the new stimulus or liquidity efforts by a further ¥10 trillion. The effect of the BoJ’s initial stimulus was to send Japanese overnight libor rates lower, pushing them back below US libor rates. That development holds significant implications for markets.
The most recent surge in the yen started a little before the end of August, when dollar libor rates dropped below yen rates for the first time since 1993. Shortly thereafter, Hatoyama’s DPJ took power, with an ostensible policy of promoting yen strength to stimulate consumption, which only added fuel to the fire. Hatoyama quickly retreated from the strong-yen notion, but the interest rate shift persisted.
Since that time, the dollar has been the preferred funding currency for hedge funds and other asset managers, fueling its slump as the new carry currency. Over that period, yen-cross correlations with risk assets (stocks or commodities) broke down, and the greenback became the primary negative correlation to risk.
As long as short-term yen rates stay below dollar rates – and the spread may widen further against the yen if reports of further BoJ liquidity injections pan out – we look for the yen-cross correlation to risk assets to return in force.
To be sure, the dollar will remain on the soft side as long as the Fed stays on hold, but currency markets may have found a new punching bag in the yen.