The Incredible Shrinking Yen

Can nothing stop the yen from falling? It is the worst performing major currency against the dollar over the past week, losing almost 0.5% and 1.8% so far this month. It is trading at multi-year lows against other major currencies besides the dollar, like the euro, sterling and the Swiss franc. Its weakness against the New Zealand dollar has frustrated the Reserve Bank of New Zealand’s efforts to cap its currency.

Many countries in East Asia, like Korea, are being squeezed by the weakness of the yen. Contrary to conventional wisdom that the weakness of the Chinese yuan is the main problem, the weakness of the yen appears more significant. Japan is enjoying a rising trade surplus with Asia (excluding China) and is offsetting the decline of the bilateral surplus with the US. Japan’s trade surplus with Asia is more than 22% above year ago levels to JPY534 billion, while its trade surplus with the US is off nearly 13% to JPY543 billion.

In contrast, China runs a substantial trade deficit with Asia and it has been doing so since mid-2000. It appears that many countries in Asia, especially Korea and Taiwan, compete with Japan in a number of areas, but have more complimentary economies with China. Of the 73 currencies that Bloomberg tracks, the yen is the weakest this year, losing nearly 4% against the dollar, while the Chinese yuan has appreciated by 2.4%. While the pace of appreciation of the yuan’s appreciation may be frustratingly slow for US and European policy makers, it is moving in the right direction. The yen is not.

On a real trade-weighted basis, the yen is trading at its lowest level in more than two decades. Japanese officials have been noticeably non-plus, content to repeat the mantra that currencies should reflect economic fundamentals. Of course they should, but the real question is which fundamentals. Although they tend not to go beyond the platitudes, the economic fundamentals policy makers seem to referring to are growth and external balances. That is fine and good and even reasonable, but the market is placing more emphasis on another set of fundamentals: interest rate differentials and yield curves. And these fundamental considerations are decidedly yen-negative.

To be sure, not every one is selling yen. In particular, foreigners have shown a nearly insatiable appetite for Japanese shares. Since the start of the current Japanese fiscal year (April 1) foreign investors have purchased Japanese stocks every week but one and for a total of around $27 billion. Foreign investors bought roughly the same amount of Japanese shares in the Jan-Mar period and purchases this year are running at about double the pace of the first half of the 2006 calendar year. While some of the recent purchases (last two weeks), appear to be being funded by the sales of Japanese government bonds, on a net basis, foreign investors have purchased about $6.5 billion of Japanese bonds in the current fiscal year and a whopping $52 billion in the Jan-Mar period.

Japanese institutional investors have also been substantial buyers of foreign assets, though in recent weeks, perhaps because of the weakness of the yen, they have been sellers of foreign assets, especially bonds. Japanese investors have sold foreign bonds in 3 of the past 4 weeks for net sales of a bit more than $4 billion. Japanese investors have been net sellers of foreign shares 2 of the past three weeks.

Despite the net inflow of portfolio capital, the yen has continued to fall. And there are anecdotal reports warning of a new wave of Japanese purchases of foreign assets as the recently paid bonuses are being ploughed into international investment vehicles. Also over the past weeks, two US investment banks sold large amounts of samurai bonds. These are yen-denominated bonds sold by foreigners in Japan. Although they did not announce their intentions, it seems reasonable to assume that the yen raised in these large samurai offerings will be converted to other currencies.

Looking at the Commitment of Traders, the recent pressure does not appear to be coming from the futures market. In recent weeks, the net speculative short yen position has been scaled back from 151k to about 127k as of June 12, which is about 25% lower than the record seen in late Jan near 173k. That said, the net speculative futures position has not been long yen since early June 2006. Given the price action it should not be surprising if the speculators at the IMM have begun increasing their short yen positions again.

Implied volatility in for the yen has generally trended lower along side the yen. Three-month implied volatility has fallen to 6%, which is the lowest level in at least more than a decade. In late Feb-early March as the yen rallied (the dollar fell form around JPY122 to almost JPY115 in about 7 days), the implied vol jumped to over 9%. The 200-day moving average of implied three month volatility is a little above 7%. The same general pattern in seen in the 12-month vols, which is a tenor that typically speculators/hedge funds avoid because it ties up to much credit.

A low vol environment is conducive for carry-trade strategies, but is also makes the carry-trade potentially more durable. Some money managers, who often are loath to pay out for a premium, might be tempted to buy a call on the yen as an insurance or hedge on the short-yen carry trades.

Japanese policy makers do not seem to be concerned about the yen’s weakness. In the US, outside of a few politicians who have large Ford and/or GM plants in their districts, the Chinese yuan gets more attention than the weakness of the Japanese yen. European anxiety, seen around the Feb G7 meeting, appears to have waned considerably since.

The Reserve Bank of New Zealand intervened in the foreign exchange market a couple of weeks ago with much fanfare as it was the first time it had done so since the currency was floated. This sparked some speculation that the Swiss National Bank would intervene to support the Swiss franc, which has the second lowest yielding currency after the yen. This did not materialize, though the franc did get stronger following hawkish comments, a 25 bp rate hike, and a snugging of the repo rate.

However, a better case can be made for BOJ intervention. It will be recalled that the as part of their extraordinary efforts to fight deflation, the Bank of Japan intervened massively in late 2003 and early 2004 and bought dollars. Even though they have not intervened since, some economists and captains of industry argue that because Japan did not unwind that intervention, that they should still be found guilty of manipulating the currency market.

The market may not be taking the risk of BOJ intervention seriously enough. Dollar sales intervention by the BOJ would serve several objectives. First, it would introduce a better two way market. Second, such an effort would deflect the criticism from US politicians. Third, it would remove some support for Chinese arguments that the yuan is being singled out. Fourth it would also help Japan reduce its hue dollar holdings in an orderly fashion.

This is not to suggest that yen intervention is imminent. Indeed it is not. But the risks are growing. With hedge fund troubles in the news in recent days and many recognizing the 10-year anniversary of the Asian financial crisis, it is interesting to recall that the only time that Robert Rubin authorized intervention after the dollar bottomed out in 1995 was in April 1998. The intervention was in coordination with the BOJ to sell dollars and buy yen. This is to say there is precedent.

If unchecked, there seems little to prevent the market from taking the dollar through the JPY125 level and possibly toward the JPY130-JPY135, the latter being roughly the last major high in the dollar in 2002. The window of opportunity for BOJ intervention would seem to grow after the July upper house elections and around the Aug BOJ meeting, where the market expects a 25 bp rate hike to be delivered and before the fall G7/IMF meetings were it may otherwise be vulnerable to renewed criticism.