What is Up with the Yen and Why it may Not Last

The Japanese yen was hands down the best performing G10 currency in April, gaining about 3.3% against the dollar and 4.2% against the euro. It appeared to start the new month on a strong note, with the dollar falling to 2 month lows in early Asia. However, in a holiday-thin European session and then in the North American session, the yen was sold off. There are several considerations that we briefly sketch here.

1. The fact that the yen strengthened underscores a key point we have made. Knowing that a country is pursuing unorthodox monetary policy (quantitative easing), does not help forecast foreign exchange prices. The BOE and BOJ are the only two major central banks still increasing the size of their balance sheets. Their respective currencies have been among the strongest.  The BOJ's mid-Feb QE announcement was different than last week's in that 1) it was unexpected; 2) it was larger and coupled with a formal inflation target, and 3) it took place amid a broader risk-on theme as the markets digested the ECB's second LTRO.

2. We have found, and the BOJ has reiterated, that the dollar-yen is sensitive to short-term (2-year) interest rate differentials. In the middle of February, when the BOJ surprised, the 2-year US-Japan spread was 16 bp. In about a month's time it had widened to 28 bp. More recently it has been trending lower and now stands at 15 bp.

3. Rarely do we have an opportunity to see something that has not been seen before and yet we are now. Back to at least the early 1990s when the Bloomberg time series began, Germany always has offered a premium over Japan. Now the German 2-year yield is below Japan's. It is only 3 bp annualized, but it illustrates disincentive for Japanese investors to export savings to Germany (or the US). Although Japanese investors were larger purchasers of foreign assets earlier this year, in recent weeks this has changed. MOF data from the last week in April will be reported later this week, but in the first three weeks of April, Japanese investors were net sellers of foreign stocks and bond in two of the weeks.  In no month since November 2011 have Japanese investors been net sellers of foreign assets for two weeks. Moreover, the magnitude of the sales in April has been sufficient to offset the net purchases of all of March and half of February.

4. The yen's earlier weakness coincided with a dramatic swing in speculative positions as recorded by the Commitment of Traders in the futures market. In the middle of January, the net speculative yen position was as long as it has been for years. The pendulum swung violently after the mid-Feb BOJ surprise and the net speculative position was by the middle of March the shortest since the crisis first broke in late 2007. The most recent report, covers the week through April 24 showed that the gross longs were continue to hover near 6-year lows (~12.7k contracts). The gross shorts peaked in the week to April 10 near 82.2k contracts and have fallen by nearly 20% since then. This suggests that the yen's strength has coincided with short-covering by speculators in the futures market, rather than new longs being established.

5. Japan reported a disappointing Tankan survey at the start of the month, but subsequent data suggests that the Japanese economy is stabilizing after contracting in Q4 11. Exports, especially to the US have picked up and this seems to be helping bolster industrial output. With help of some government assistance and the reconstruction (both in Japan and Thailand) Japanese autos sales have improved significantly. In April, Japanese auto sales were an incredible 92.6% above the year ago level.

6. Often, market participants conceptualize the yen sensitive to the broader risk appetite. We argue that at the heart of this relationship is not the safe haven as is often claimed. After all Japan is a country with a debt/GDP ratio more than twice the US. It has long lost its AAA rating. Instead, we tend to emphasize its international investment creditor status. This means that when tensions/anxiety rises, Japanese investor keep more of their savings at home. This results in the failure to recycle the investment come, which has been the key factor keeping the current account in surplus even as the trade balance fell into deficit. We note that from early August 2011 through early March, the yen was positive correlated with the US S&P 500 (60-day rolling basis on percent change). In recent weeks, the yen (not dollar-yen) has been inversely related to US stocks. Maybe another take is think about Spanish bonds as the risk asset rather than US shares. From Aug 2010 through the end of March, the yen was inversely correlated with Spain's 10-year bond yield. Since the beginning of the month, the correlation has swung around and now the yen is positively correlated with Spanish 10-year yields.

7. Technically, it appears the yen has put in a near-term high.The dollar's low today has corresponded to almost a 61.8% retracement of the rally from early Feb near JPY76 to the mid-March high just above JPY84.00. Momentum indicators and the recovery to new highs late in the session may signal the market reject the sub-JPY80 level. The first test is seen in the JPY80-50-70 area and a break of it could see a move toward JPY82 initially, but possibly a retest on the JPY84 area. A significant caveat is the weekend elections in Europe. If the election of the a Socialist in France and the fragmented parliament in Greece, where the critics of EU may hold the whip hand, risk appetites could wane and lend support to the yen.