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Support For The Yen
By Darrell
Jobman
Is the yen
really turning around?
Over the
last five years, the Bank of Japan has been engaged in a prolonged
battle to combat deflation in the Japanese economy to bring
conditions back to “normal.” The central bank already cut interest rates to zero in 2001 but
took the additional step of flooding the market with excess
liquidity. The bank adopted a quantitative policy with a target of
30-35 trillion yen for current account deposits held by the
commercial banks.
A second element of
the policy was to intervene aggressively to prevent yen strength as
a stronger currency would have put further downward pressure on
domestic consumer prices. The Japanese central bank, under the
direction of the Finance Ministry, intervened heavily to prevent yen
gains through the 100 level against the US dollar in the first
quarter of 2005, although there has been no need to step in over
the last 12 months, given the general dollar gains.
Victory against deflation?
In recent months the Japanese economy
has been displaying solid evidence of an economic recovery. Growth
measured by gross domestic production recorded an annualized gain of
more than 5.0% for the fourth quarter of 2005, supported by solid
gains for production, investment and consumer demand. Bank lending
growth has also returned to positive for the first time in more than
five years.
As far as inflation is
concerned, there was an underlying increase in consumer prices of
0.5% in the year ended January 2006, the third consecutive annual increase, and
the increase was the most convincing indicator that deflationary
pressure is easing. Positive inflation data was also an important
condition set out by the Bank of Japan for returning to a more
conventional monetary policy.
After the March
monetary meeting, the Bank of Japan announced that the quantitative
monetary policy was being suspended. It will be replaced by interest
rate targeting and a reference inflation target range of 0-2 %. The
bank will reduce excess liquidity in the banking sector gradually
over the next few weeks as conditions are normalized.
Interest rates stay low
Despite the policy change, the Bank of
Japan will act to keep interest rates at a very low level, with short-term deposit rates remaining at close to zero. Short-term interest rates are likely to rise
gradually from the third quarter of 2006, with rates of close to
0.75% realistic by the end of 2006.
Nominal interest
rates will, therefore, remain very low in a global context, which
will lessen short-term yen buying interest based on interest rate
yields. The withdrawal of excess liquidity will, however, still have
an important impact in lessening yen supply, and this will be very
important in stemming underlying yen selling pressure.
Nominal bond yields
have already risen, with five-year yields rising to a five-year high
at close to 1.2% while 10-year yields are at 1.7%. Historically,
yield spreads on bonds have been very important indicators of
currency trends, and any narrowing of the yield gap between U.S. and
Japanese bonds would support the yen.
Impact of carry trades
Carry trades have been a very
important feature of currency markets over the last six months.
Funds and, increasingly, individual investors have borrowed funds in
low-yield currencies to invest in high-yield currencies and
speculative assets. The target investments have included currencies
such as the Australian and New Zealand dollars as well as emerging
market instruments such as the Brazilian real and Mexican peso.
Commodities and energy instruments have also benefited from the
trend.
“The currencies
most vulnerable to selling pressure have been the yen,
Swiss franc and euro due to their low-yield structure, with the yen
particularly vulnerable, given that short-term interest rates
remained at zero,” notes Matt Blackman, market analyst at
www.TradingEducation.com. “A gradual tightening in global liquidity
and more restrictive Japanese policy would make it much less likely
that the yen would be a selling target.”
The Japanese
current account surplus fell by 7.6% in the year ending January to 719
billion yen as the trade account was undermined by high oil prices
and a seasonal drop in exports. However, Japan will continue to run
a substantial basic balance of payments surplus during 2006.
The income account
will also be a very important focus over the next few months with
the potential for further strengthening. Japan’s foreign exchange
reserves have increased to more than $800 billion, still primarily
invested in U.S. Treasury bonds, while there are substantial
holdings of U.S. bonds held by Japanese investors.
An important and
rising flow of funds will be moving back to Japan in the form of
interest payments. Although these funds may be recycled overseas, the structural capital account surplus will offer
important background yen support. These flows will be particularly
important in supporting the yen if wider dollar confidence starts to
weaken.
Holding its own
Since pushing to
the 102 level in late 2004 and early 2005, the yen has
remained in a
more comfortable area for Japanese policymakers in 2006.
Regional support
Regional currency policies will also
be important for the yen. There is a strong case that the underlying
economic fundamentals will put upward pressure on the Chinese
currency. US political pressure for stronger Asian currencies is
likely to increase ahead of the November congressional elections.
Any Chinese yuan appreciation would be liable to trigger wider Asian
currency gains, especially if there is growing trade protectionism
and U.S. political pressure over the U.S. trade deficit.
There will
certainly be the risk of currency depreciation at times, especially
if there is a withdrawal of equity funds from Asia, but the
underlying trend is likely to be of appreciation.
Japan’s position in
Asia is complex, given the contrast between the rapid expansion of
low-cost manufacturing production in China and the much more mature
industrial economy in Japan. It is, therefore, dangerous to assume
that Asian gains would automatically translate into yen gains.
The Japanese
economy is also still dependent on export growth, and a general
downturn in the global economy or a cyclical decline in the U.S.
economy would put the Japanese economy under pressure again.
Nevertheless, sustained Asian currency appreciation would be likely
to support the Japanese yen and could trigger opposition to yen
gains from within the Japanese Finance Ministry.
Dollar yields crucial
The Federal Reserve cut interest
rates to a low of 1.0% in 2004, eroding the dollar’s yield advantage
over the yen. The yield gap on 10-year bonds hit a low in the third
quarter of 2004, with the dollar/yen rate hitting a low close to
102.0 early in 2005. There has been a gradual recovery in the yield
gap and dollar since then as the Fed has steadily increased interest
rates.
U.S. bond yields
have responded to a lesser extent, but the dollar’s advantage has
improved slightly. This has helped push the dollar to a stronger
position against the yen. The dollar will be more vulnerable once
U.S. interest rates appear to have peaked as yields would be likely
to decline from that point.
Given the extent of
dollar holdings held by Japanese and Asian investors, there is
always the risk of a sudden loss of confidence in the U.S. currency.
Overall, structural factors and a savings surplus point to
underlying yen appreciation.
Darrell Jobman is Editor-in-Chief of
www.TradingEducation.com, which provides free daily and weekly
commentaries for traders. He is an acknowledged authority
on the financial markets and has been writing about them for more
than 35 years.
Source:
TradingEducation.com |
