The Yen's Surprising Rally

by: Ivan Martchev

With all the talk of what oil is going to do next and what happens in China in 2016, many observers have not paid close attention to the monstrous move in the Japanese yen in the last two weeks. I think oil is going to go where the Chinese economy goes, as China is the biggest consumer of oil at a time of surging global supply.

In a roundabout way, the yen will also go where the Chinese economy goes, as any further complications in the economic situation in China will likely cause more carry trade unwinding and a stronger yen at a time when the Bank of Japan (BOJ) is targeting precisely the opposite - a weaker yen.

United States Dollar versus the Japanese Yen - Daily OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

When the BOJ moved toward negative short-term interest rates at the end of January, I opined that a strengthening of the yen was possible even though the BOJ was targeting a weaker yen. (See Navellier Marketmail for February 1: "The Short of the Century May Last Quite a Bit Longer"). However, I am rather surprised to see how fast the currency markets humbled the BOJ by delivering a monstrous move in the opposite direction than the BOJ was targeting. To compare the magnitude of the yen move, it is bigger than the August 2015 swoon in the yen that was driven by the Chinese token devaluation. It is also just a bit smaller but comparable in magnitude to the September 2008 yen move when Lehman Brothers failed.

Why does the BOJ want to see a weaker yen?

A weaker yen would help Japan fight the deflation that has been entrenched in Japan for over 20 years. Also, the Japanese stock market, as measured by the Nikkei 225 Index, is notoriously correlated with the yen. While profits for the S&P 500 Index are about 40% from international operations, for many major Japanese corporations in the Nikkei 225 Index the global profit ratio is higher, hence the tight correlation with the yen - the Japanese currency and the Tokyo stock market look almost like a mirror image.

Tokyo Nikkei Average Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The Nikkei moves in a leveraged manner (in greater magnitude) to the yen as the yen affects the value of corporate revenues outside of Japan. Those global revenues have a magnified effect on profits. For instance, a 5% move up or down in the USDJPY exchange rate can mean a 10% move up or down in the profits of a Japanese corporation depending on the level of its profit margins.

Obviously, different companies have different leverage to the yen, but since the Nikkei 225 Index is a large-cap index that includes most of Japan's famous exporters, the leverage to the yen is outsized (see chart). So when targeting a weaker yen, the BOJ actually targets a stronger Nikkei 225 Index and a positive wealth effect for Japanese consumers (as perverse as this may sound to hard-money aficionados).

How high can the yen go? (Note: A high yen means fewer yen per dollar on the inverted USDJPY chart.)

I do not believe in setting precise targets as in reality they are an exercise in futility but I do believe that it can go higher even though the BOJ wants it to go lower. Keep in mind that recently-announced negative rates will be imposed on reserves worth about 10 to 30 trillion yen and will apply only to new reserves that financial institutions deposit at the central bank. There are three tiers of BOJ reserve balances that are affected by this so as to facilitate a gradual implementation of the negative interest rate policy. (See Bloomberg, January 29, 2016: "Bank of Japan's Negative Interest Rate Decision Explained.")

  • Existing balances will continue to have a rate of 0.1%. This will be called the Basic Balance.
  • A rate of zero percent will be applied to reserves that institutions are required to keep at the BOJ, and reserves related to the bank's lending support programs. This is the Macro Add-on Balance/strong>.
  • A rate of -0.1% will be applied to any reserves not included in the first two tiers. This is the Policy-Rate Balance.

Ten Year Japanese Government Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This negative-rate central bank maneuver has caused Japanese 10-year government bonds (JGBs) to trade down to -0.03% in yield and in the process become the second 10-year government bond in the world to have a negative yield. (The other is Switzerland, whose rates have been as low as -0.38% recently.)

Global Market for Negative Interest Rate Debt Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

There is $6 trillion of government debt globally right now that trades at negative yields but most of it has been at maturities of five years or lower. The fact that we now have two governmental bond markets that have recently registered negative yield on 10-year bonds is indicative of global deflation, in my opinion.

Deflation happens when too much debt piles on in the financial system and borrowers decide it is in their best interest to de-leverage. Debt-liquidation in an over-leveraged financial system - and the subsequent refusal to increase borrowing - can last for decades. This is certainly the case in Japan, where low and now-negative interest rates are not working in order to promote more borrowing. This was certainly the case in the 1930s in the U.S. And I believe it will be the case in China, whose epic credit bubble is deflating as I write. (See my February 3, 2016 Marketwatch article, "Something Broke in China in 2016.")

Will the Chinese Devalue the Yuan?

The short answer is Yes.

Chinese forex reserves are flowing out of the country at a rate of $100 billion per month. The reserve totals are typically reported over the weekend once a month, so Saturdays on the day they are reported have become a day that delivers what has become a really important economic number - when the markets are closed. Even though China's forex reserves stand at $3.23 trillion, as reported by the People's Bank of China, I do not believe that is enough to maintain the yuan peg as the likely losses from the unravelling credit bubble in China may be considerably bigger than the value of those reserves.

Credible estimates for non-performing loans (NPLs) that I have quoted before in this column are 6-20% of total loans and rising. The high end of that estimate wipes out the value of all Chinese forex reserves. This would leave the Chinese government no choice but to devalue by 20-40%. The last time they resorted to such a measure, they devalued by 34% in 1994 as you can see in the chart below.

China Foreign Exchange Reserves

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The yen is likely to be moved further by a Chinese devaluation. Right now it is appreciating as multiple carry trades are unwinding, even though the BOJ is doing whatever it can to push the yen lower. The unwinding of carry trades is due in large part to the deteriorating situation in China, which has caused multiple economic problems in favorite carry-trade destinations like Brazil.

If the Chinese do devalue - which I believe they will, probably in the next 12 months if not sooner - the yen and the dollar are both likely to go quite a bit higher. Imagine the second-largest economy in the world, with GDP of $11 trillion, having the value of its exports getting cheaper by one-third overnight. What are China's biggest competitors going to do, other than to try to lower prices in order to survive?

A Chinese devaluation is highly deflationary and will cause more unwinding of carry trades (in the case of the yen) and a bigger safe haven bid (in the case of the U.S. dollar).

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