Yen Weakness Explained

One of the most puzzling developments in the foreign exchange market has been the persistent weakness of the Japanese yen.

Macro-economic fundamentals appear strong. Japan’s pace of growth puts it near the top of the major industrialized countries. Japan enjoys a booming stock market, with its year-to-date gain of 34% easily topping the G7. Moreover, the vast majority of those gains have been scored here in the second half. In terms of external although higher energy prices have eaten away at Japan’s trade surplus, its exports remain strong, having risen by almost 9% on a year-over-year basis.

Yet the yen is weak. On a real effective basis (essentially adjusted for inflation and weighed according to trade flows), the Bank of Japan’s calculation indicates the yen has not been this weak since the mid-1980s. For its part, the dollar is trading at its best level against the yen since spring 2003. The dollar has gained about 15% against the yen this year, a bit better than the 14% gain against the euro.

It is clear that whatever drives the foreign exchange market, it is not a simple assessment of growth differential. This year is the 13th out of the past 14 that the U.S. growth surpasses the euro-zone’s growth. And of course, over these years, the dollar’s performance has been mixed. This year will also be the second consecutive year that the Japanese economy grows faster than the euro-zone and net-net the euro has appreciated a little more than 7.5% against the yen over these two years.

Sphinx Riddle Resolved

Nor can the yen’s weakness be attributed to intervention by the Bank of Japan. The Bank of Japan reports monthly its intervention and it has not intervened in the foreign exchange market since mid-March 2004. In fact, its abstinence is the longest since the Ministry of Finance began its record keeping in the early 1990s. And even more to the point, Japanese intervention has historically been largely ineffective. When the BOJ stepped up its intervention from September 2003 through mid-March 2004, the dollar remained under pressure. It was only after they stepped away that the dollar firmed in spring 04 to record the high for the year near JPY115.

Rather than manipulating the foreign exchange market, the source of the yen’s weakness is the similar to the reason the dollar was weak until earlier this year: In one word, interest-rates. Japan’s overnight interest rates remain stuck near zero. Investors and speculators are essentially paid to be short the yen. One by one the other potential candidates for providing the financing currency have raised interest rates.

It is true that the Bank of Japan has signaled its intentions to end its extraordinary accommodative monetary policy. However, there are several mitigating factors. First, the BOJ has indicated that its initial measure will be to reduce the amount of liquidity it currently provides to the banking system and that this could be implemented without raising short-term interest rates. Second, Japanese government officials and some multi-national institutions, like the OECD have urged the BOJ to be patient and avoid repeating earlier mistakes of premature tightening which undermined the nascent recoveries previously. Third, even when Japanese rates rise, there is little doubt they remain low in absolute and relative terms.

Some observers think that because foreign investors have bought something on the magnitude of $75 billion worth of Japanese shares this year that the yen should be higher. Yet this too is mitigated by several factors. Foreign purchase of Japanese shares is not the same as demand for the yen because often the equity purchases have been financed by shifting money out of the Japanese bond and money markets. Although equity investment often has lower currency hedge ratios than bonds, there have been indications that some of the institutional equity investors have hedged more of their yen exposure.

Foreign purchases of Japanese shares have also been offset by the seemingly insatiable Japanese appetite for foreign bonds. Interest rate differentials are the one of the mina driving forces behind these capital outflows from Japan. But here too hedging decisions may be playing an important role.

When the U.S. yield curve was steep, investors could buy the long-end of the curve and hedge out the currency, by selling dollars, and still lock in the bulk of the interest rate pick-up. Now with the U.S. curve exceptionally flat, investors are denied a key incentive to hedge the currency risk. And indeed, Japanese life insurers have indicated that they are buying more bonds on an unhedged basis.

These considerations have also encouraged speculators to amass a significant short yen position. This is, at least, in part, picked up by the Commitment of Traders, where the net non-commercial (speculative) short yen positions are near record levels. Speculative players may have also been emboldened by the deafening silence of official concern.

Indeed quite the opposite. Japanese officials who have commented on the foreign exchange market have suggested not only a comfort with the dollar-yen movement, but that the stronger dollar accurately reflected economic fundamentals. U.S. officials have also been quite circumspect. When the market thought that U.S. Treasury Secretary Snow had indicated that the yen’s weakness was to be discussed at the G7 meeting, the Treasury Department was quick to issue a clarification, which put the reference to the yen within the context of normal ongoing discussions.

Yen Weakness to Persist

With brief and shallow pullbacks, the dollar’s rally against the yen has been especially pronounced since mid-September, when the dollar was trading near JPY109. During this time, the implied 3-month volatility has trended lower from the mid-8% area to about 7.8% near mid-week. However, when the dollar moved above the JPY120 level, implied volatility moved higher as the market braces for another leg up in the dollar.

The net key objective for the greenback comes in near JPY122.40, which corresponds to a 61.8% retracement of the slide from the early 2002 high near JPY135 to the low recorded early this year near JPY101.70. Momentum indicators and market positioning warns off the risk of a near-term dollar pullback. The JPY120 level, which previously offered resistance, should now provide initial support. Additional support is seen near JPY119.50. A bout of profit-taking that pushes the dollar into this support area will likely provide a new low risk point to enter new long dollar positions.