THE MYSTERIOUS RISING YEN / THE ECONOMIST ( VERY HIGHLY RECOMMENDED READING )

The mysterious rising yen

Aug 5th 2010, 8:54


by Buttonwood

THE Indian rope trick is a legendary feat of magic in which a boy climbs a rope only to disappear into thin air at the top. It sometimes seems as if the yen has perfected the art. On August 4, the Japanese currency reached a 15-year high against the dollar of Y85/$. It is not that far away from its record peak of Y79 (see chart). In the meantime, another apparent mystery emerged with the yield on the 10-year Japanese government bond falling below 1% for the first time in seven years; this in a country with a gross government debt/GDP ratio of around 200%. Low borrowing costs may be welcome news for the Japanese authorities but a stronger yen is not. Trade minister Masayuki Naoshima has said

I am really concerned about the yen's recent rise...Japan's companies are now competing with Chinese and south Korean firms. In China and south Korea, their currencies are linked to the US dollar so in that sense they don't face currency risks. But Japanese firms are facing huge currency risks...in that sense, we may need to take some sort of action in the future.

Foreign exchange markets go in phases but there seem to be four basic factors that drive currencies: yield differential, relative economic growth, current account deficit/surpluses and relative inflation. Clearly, investors and traders are not buying the Japanese currency for its yield, either short- or long-term. Indeed, for years, the yen was forced down by the carry trade, with investors borrowing in Japan to buy higher-yielding currencies elsewhere.

The second factor is relative economic growth; arguably, this has been driving the euro up against the dollar over the last couple of months. And it is true that Japan is expected to have a better year than normal in 2010, with growth forecast at 3.1%. But that is only on a par with forecasts for America, and the rate is expected to subside to 1.7% by 2011. Surely markets are supposed to be forward-looking?

Then there is the current account surplus. Clearly, one reason for the yen's long-term strength is that its trading partners have not been accumulating unwanted yen; as a result, its government debt is owed mostly to its own citizens. The current account surplus is expected to be 3.6% this year. but the surplus is down from 4.7% in 2007. The legendary Japanese savings rate is down from its 1990 levels, even when one allows for the huge surpluses of corporations; the ageing population is starting to run down its savings as it retires.

So that leaves the inflation rate. Peter Tasker, in an excellent piece (http://www.ft.com/cms/s/0/81552e06-9fe2-11df-8cc5-00144feabdc0.html) in today's FT, argues that this is the driving force. He thinks that deflation is even greater than the official estimate of 1.5%, which means that, even at 1%, Japanese bonds are offering a very nice real yield. He also argues that the yen is much more attractive than gold, which is being bought for irrational motives, given the lack of inflationary pressure. Mind you, he admits that

There is a wrinkle. The supply of gold is small and constrained, whereas the Bank of Japan can create as much yen as it likes. This is exactly what several foreign observers, and, increasingly, Japanese politicans have been recommending.

To me, this seems quite a big wrinkle and explains why buying gold is not completely irrational. But it is an interesting line to pursue. One could see gold priced in yen as a measure of the market's views on the deflation/inflation question (see chart). The trend was upwards for much of this decade, except for the period when the credit crunch was biting hardest. The recent fall in the gold price in yen terms is hard to spot on a long-term scale. But it seems plausible that the yen's strength and the decline in bond yields indicate that the markets are currently edging towards a deflationary view. The drop in the 10-year Treasury yield below 3% would confirm that interpretation. But if that's right, it is hard to see how July's rally in equity markets can be sustained for long. Albert Edwards of Societe Generale thinks the US is still following the Japanese template, with the conference board leading indicator signalling a renewed dip into recession.