Just after the Bank of Japan reduced overnight rates one step further, going below zero (joining the ECB), would anybody expect the yen to rise in the coming period? Not many, but I do. The currencies market didn't seem impressed either. And I have some rationale behind my belief.
Why have the yen and the euro collapsed recently? Has it been because of their economic troubles, or their central banks' intention (though never admitted) to devalue their currencies? It is true that both Europe and Japan have serious economic problems. Europe has far greater fundamental economic issues than Japan. That's why I'm not touching the euro. The whole developed world (as a whole) has been on a private sector deleveraging spree since the crash of 2008, because interest rates have been unable to make significant strides downwards as they used to in past recessions (ample explanation in my previous, very long, article). This private sector deleveraging (companies and households unwinding their excess debt) process has been, and still is, deflationary. The least competitive economies suffer the greatest, hence Japan and Europe have been far more affected than the US. The US has been on a general private sector deleveraging process too, but mostly because of household deleveraging (who suffered a great confidence blow after the housing crash).
The Bank of Japan (BOJ) and the ECB (European Central Bank) decided to make their currencies cheaper, exporting some of their deflationary pressures abroad. They did this using QE to buy Treasuries, pushing yields lower, hence making their currencies less attractive. And they succeeded only because the US did not follow the same policy any longer, allowing the market to decide where US Treasury yields should be. The market, taking into account potential Fed rate hikes, and perceived expectations for inflation, gave US Treasuries much higher yields than Japan and European countries, especially Germany (with the most solid government). And this situation has been going on since 2012 in the case of Japan, and 2014 in the case of Europe.
Private deleveraging is a very interesting phenomenon when you look at different countries and their currencies and how they behave. There are countries where private deleveraging is associated with deflationary pressures, because they have sophisticated economies and strong governments, and there are countries where private deleveraging is associated with inflation. Not many countries 'afford' (in a perverse sense) deflationary deleveraging. Most countries in the world have currency crashes when there is a significant private sector deleveraging. Greece suffered (and is still suffering) from a massive deflationary environment because it does not have its own currency. If Greece had its own currency, the currency would be massively devalued because of market forces, and instead of deflation Greece would have had very high inflation. And I believe it would have been much better for them, but this is another matter. Very few countries can actually afford deflation on their own. Most countries with independent central banks have no choice but to suffer very high inflation whenever there is any kind of serious private sector deleveraging. They can be democratic, autocratic, export oriented, import oriented, large, small etc. The financial world treats them all equally in this sense. They are destined to have what we could call failed fiat currencies.
I'll try to make a short analysis of the world's most important currencies to see which one is most likely to do best in the coming period.
The US has of course the privilege of being the oldest continuous democracy in the world with the best reputation for balance and budgetary conservatism, and this gives the US dollar a unique status. The US can run huge deficits, take on huge amounts of debt, or even significant economic risks, without much scrutiny, simply because there is no real alternative to the US dollar. This may sound bizarre to many Americans, but the rest of the world is so bad that America has turned out to be the least bad. Size (and therefore liquidity) has also been very helpful.
China is neither a democracy nor a real and transparent market economy. It hasn't built a credibility yet either. Most Chinese citizens remember that their currency lost most of its value (chart below from ycharts.com) from the early 80s until 1994. The devaluation was massive, but most Chinese were terribly poor back then and did not have their current aspirations either.
The above reality-check, coupled with the fact that Chinese citizens (let alone outsiders) do not see their government as legitimate, trustworthy, or in fact balanced in any way, make the yuan a very poor contender to join the club of valuable currencies (my past article on the yuan).
Which one of the existing major (and credible) currencies are going to do best in the near future then? This is indeed a very important question, as I believe we are at an important crossroads. This year we will most likely, finally, observe that using QE to devalue currency does not work anymore among developed economies. This will probably be devastating news for Europe and Japan, but they will just have to deal with their deflationary realities and not expect to be able to export much to the rest of the world any longer. I expect US yields to follow Japanese and European yields and go toward zero, as deflation will become a reality, not just in Japan and Europe, but also in the US, and the whole developed world - as there will also be much higher inflation in less developed economies.
If US yields fall significantly from their current levels, approaching zero, is it possible for German and Japanese yields to go in similar magnitude below zero? For example, if US 10-year bond yield falls to 0.50% (from almost 1.80% now) is it possible for Japanese 10-year yield to fall 130 basis points, from almost zero to -1.30%? What about German yields - can they fall 130 basis points, from 0.30% to -1%? In case they can, then the dollar can stay as strong compared to the yen and the euro, but in case they can't, the dollar will have to fall against these two major currencies. The fall may not to be dramatic, because after-all the US will maintain its relative economic strength and stability.
Is it possible for the ECB and the BOJ to succeed, or indeed to wish, to push their yields so far below zero? Would that be effective? Would it actually be useful at all? Taking 10-year yields so far below zero (to -1% or lower) will mean taking overnight rates significantly below -1%. It is not impossible, but is it plausible? Negative interest rates, below a certain level, completely lose their punch, as they make commercial banking pretty much impossible. Central banks do not deal with the private sector directly - they need commercial banks to implement their monetary wishes. Commercial banks cannot pass negative interest rates on to their loans. They just have to absorb it beyond a certain limit. Lending at zero interest rate for commercial banks makes no sense, since they cannot make any profit. Intentionally choosing to make even a small loss is not an option either. Commercial banks can choose between lending at positive interest rates, and not lending at all. And they can choose not to lend at all, doing more harm than good to the economy. Central bankers know this. Negative interest rates cannot go far below zero, especially for major currencies. Its real impact, in fact, can only be devaluation, but even that cannot be maintained for long after a significant amount of deflation has already been exported. Exported deflation for a sustained period of time, using negative interest rates etc, can ultimately reduce inflationary expectations of trading partners, and this in turn would push interest rates of trading partners lower, rendering the action (pushing interest rates lower) futile over the long run. In case it does not produce results, and kick-start the economy, in the short-run, it loses its effectiveness over the long run by pushing the interest rates of trading partners lower. Europe and Japan are huge economies, and their exported deflation is not something to be taken lightly. This, together with the exported deflation of China since last year, is the perfect storm for some serious deflation all around the developed world.
Therefore, it is very unlikely for Europe and Japan to be able to do much, either with their negative interest rates, or QE, to further devalue their currencies, or even keep their currencies undervalued. Both of them, as of now, seem to be good candidates for currency appreciation against the US dollar, as US Treasury yields can fall a lot, while European and Japanese yields will not be able to fall much. And this reduced gap between yields will push the dollar lower, and euro and yen higher against the dollar. However, there is one huge problem with the euro. Europe is not done with its domestic crises. Europe has not dealt with its huge problems in Greece, or even in Spain, Portugal, and finally Italy. Italy and Spain are too big to fail as separate countries, but they can definitely bring the failure of the whole European common currency. Greece is still in an economic depression. Spain and Portugal are very likely to blow up worse than in 2012 with the occasion of the next economic slowdown (which seems to be just around the corner). This is why I would rather not touch the euro.
However the yen is cheap (it has lost 35% of its value since Japan's massive QE since 2012), and it has the potential to close its artificially created gap with the dollar as US interest rates go lower. Japan has some serious issues too, especially the biggest public debt in the world at over 230% of GDP. However having a huge government debt, when the government practically pays no interest for the debt, is not that big a problem, but Japanese economy will also suffer, and a lot more than the US, in the eventuality of an economic slowdown. That doesn't necessarily mean that the yen will fall against the US dollar. The yen rose against the dollar after the crash of 2008, and Japan was not in a particularly good spot even back then (chart below).
I think it would be fair to assume that a further fall in US yields would at least push the yen to 100 against the dollar, or far higher. It would be very bad for Japanese exports, but I doubt there is any way around it. There is no other scientifically proved mechanism of devaluing a currency yet. And this particular method of devaluation, pushing short term and long term rates lower (cutting overnight rates and QE), has its limits. It seems true, after-all, that you cannot really print growth, or prosperity!
But isn't there a real risk, that at some point, even credible fiat currencies of the developed economies also start to shatter? The real obstacle here is the lack of an alternative. In case there was a major economy out there with a strong and democratic government, with virtually no debt, and healthy growth potential, then of course its currency would attract most of the capital from around the world and it would have been a true preserver of purchasing power. Nevertheless there is no such economy out there. The only real options are the US dollar, the euro and the yen. The euro has its unique existential risks (it faces a real possibility of disintegration), so let's just focus on the dollar and the yen. At some point the dollar and the yen can also lose credibility, because of too much fiscal and monetary abuse (and abuses have been aplenty in recent years). But that will not mean a collapse for either of the two. There is simply no alternative for them. Investors are not going to dump all dollars and yens and pile on gold or bitcoin. Gold or bitcoin cannot function in today's economies as real means of trade. They are simple subjects of speculation for the moment. Therefore the only real risk for the dollar or the yen will be high inflation at some point in the future. But that seems to be at a very distant future for now. The world has not even entered a truly deflationary cycle yet. We have been through a rather continuous, more or less mild (or benign) inflationary environment since the 1930s. It is very unlikely that an end to decades of debt accumulation (especially since 1980) can be managed so well that we neither get deflation nor hyper inflation, but rather moderate inflation. And since creating hyper inflation is far more dangerous than deflation (like in Weimar Germany, or more recently Zimbabwe and many other developing countries) it is safe to assume that authorities (particularly in the US and Japan) will not completely debunk the credibility of their currencies and will prefer to face a (hoped for) moderate deflation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am short USDJPY.