Macro Summary: Japan and the Yen

The Japanese yen is the best performing currency so far here in May. It has appreciated by roughly 1.25% against the dollar. The same forces that lift it are also boosting the Swiss franc (mtd 1%). The investment climate has turned in a decidedly less supportive direction following the end of the US-China tariff truce, heightened tensions between the US and Iran, and miscue after miscue in the UK raising the possibility of a disorderly exit from the EU.

Here is a thumbnail sketch of the macro forces driving the yen's exchange rate.

1. The Japanese economy is not in as poor shape as it may be perceived. The external disruptions by the US-China trade tensions, the slowing of the Chinese economy, the end of a capital investment cycle in China with semiconductor fabrication plants, and uncertainty over Japan-US trade talks are the biggest cross-currents, to use Fed Chair Powell’s term.

2. Growth in Q1 surprised nearly everyone. The world’s second-largest economy expanded by 0.5%. Most had anticipated a contraction. Consumption did fall as did business investment, though not by as much as had been projected. The decline in imports, which fell faster than exports, saw a positive contribution from the external sector. Also noteworthy is the fact that the GDP deflator returned to positive territory (0.2%) after falling (deflation) in the previous three quarters. A key takeaway is that the sales tax hike planned for October 1 after a couple of delays, will most likely go forward. To say it a different way, the bar to delaying it again is very high.

3. Prime Minister Abe and President Trump meet this weekend. Trade talks will get underway. The April trade figures were released earlier this week and showed exports to China fell (6.3% year-over-year), which includes more than a 40% decline in equipment for making semiconductors. Exports to the US rose by 9.6%. Overall, exports have been contracting on a year-over-year basis since December. In April, they were off 2.4%. Japan's current account is no longer driven by the trade account but by the investment income account (e.g., profits, royalties, licensing)

4. Trump has given foreign automakers, including Japan (and Europe) 180-days to address the auto trade imbalance. The threat is 25% auto tariffs after the US Commerce Department investigation concluded that auto and auto part imports were a threat to national security.

5. The Japanese yen does not appear to be typically sensitive by Japan’s domestic developments. Instead, the yen’s use as a funding currency to purchase higher returning and more volatile assets seems a more powerful driver and explains the “safe-haven” perception. Consider that the dollar typically rises against the yen when the MSCI Emerging Market equity index rises (60-day rolling correlation of percentage change is near 0.40 and is in the upper end of where it has been in the past three years). Similarly, the correlation (percentage change) with the dollar-yen exchange rate and the S&P 500 is near 0.55. It has not been much above 0.60 since the end of Q3 15.

6. The dollar-yen exchange rate also seems sensitive to interest rates. Interest rates differentials (and a stable to weakening currency) are part of what makes using the yen as a funding currency attractive. The exchange rate correlation with the US 10-year yield is near 0.65. It has not been above 0.75 this year. The correlation with between the dollar and the two-year Treasury yield is firm a little above 0.60.

7. Three-month implied volatility is near 6.25%. When the yen appreciated in the immediate response to the end of the tariff truce, the implied vol jumped to almost 7.2%, a three-month high. Volatility appears to rise when the dollar sells off. The 100-day moving average is near 6.45%. The three-month put-call skew (risk-reversal) saw dollar calls go to a 2% discount to puts as the greenback tested JPY109 in the spot market. The skew (-1.7% 25-delta risk-reversal), which is still relatively large (100-day moving average is near 1.3%). Japanese exporters are long dollars and often sell calls (or buy puts) to hedge, so the skew typically shows a discount for calls.

8. The Bloomberg survey found a median three-month forecast of JPY110.00. The interest rate differential, which determines the forward, is around 30 pips a month (ballpark). Analysts generally are dollar bearish for everything but the most immediate time-frames. In a year the median forecast is for the dollar to be at JPY108. The implied forward is indicated around JPY107.30.

9. The dollar-yen exchange rate often seems range-bound. The JPY108-JPY112 trading range that has contained the price action since early January can persist for some time. The risk, though, does seem to be asymmetrical. Tensions between the US and China, and possible drama in the US-Japanese talks (even though Abe appears to have tied his best to ingratiate himself with the mercurial American president), as well as geopolitical flash points (Iran, North Korea, Venezuela) are threats to a stable yen.

10. Japanee investors took advantage of the strength of the yen following the end of the US-China tariff truce to accumulate more foreign bonds. In the week ending May 17, Japan bought JPY1.35 trillion (~$12.3 bln) of foreign debt. On the other hand, speculators in the futures market have begun reducing their net short yen position. It was the largest of the year at the end of April near 100k contracts (JPY12.5 mln per contract). Most of the decline in the net short position is accounted for by the reduction in the gross short position (short-covering).