Yen Outlook: Stronger on Japanese Economy or Weaker on Carry Trade Comeback?

The Japanese yen has gained close to 12% over the last year, and from June 2007 to March 2008 it gained close to 24% or so going from 125 per US dollar to touching 95 Yen per dollar. The key question is whether it keeps this momentum up, or whether it’s now time to bet against this strength?

Well in my opinion, a big part of this strength can be attributed to:

• Carry trade reversal: Some argue the Japanese yen has been one of the biggest sponsors of liquidity in the global financial market with 0% interest rates for a long time (right now it's 0.5%). Indeed one of the favorite carry trades was borrowing in Yen and investing in Australian dollars, US or even Iceland among others. But as global financial markets went wobbly amid the sub-prime crisis, this carry trade was reversed by buying back Yen, leading to its strength.
• Economy: Right when US economy was heading towards recession (Note using ‘heading towards’ not ‘into’), the Japanese economy was showing signs of much sought after inflation after more than a decade of deflation. Indeed the latest data showed that inflation was close to 1.2% in March.

But recently, credit markets have certainly improved easing the “credit crunch”, as:

• Loan spreads have moved from 850bps to 640bps range in a matter of months
• Midway through last year, the inventory of unsold loans were close to the $200b range and unsold bonds were close to $100b. Now they each stand close to less than half of that number.

So, maybe it’s better to bet against this Yen strength. Here's why:

• Inflation data has definitely cheered a lot of folks, but if we take out energy and food costs, inflation was a mere 0.1%. So as food and energy costs reverse, I expect Japan's central bank to hold rising interest rates. Now why food and energy might reverse? I would say on a stronger US dollar.
• Why would the Japanese central bank hold interest rates or even decrease them (note: remote chance in my opinion)? First, being an export-led economy, Japan's central bank has almost always (at least as long as I’ve been watching) supported a weaker yen, especially against the US dollar. Secondly, after a decade of deflation, they are less concerned about inflation threats to the economy and may want to see clear signs before raising interest rates, including new governor Mr. Shirakawa. By the way, in the latest Tankan survey, exporters said the break-even Yen rate for them is 104.7 per dollar (right now it’s hovering around 104.4).
• Last but not least, the comeback of risk may be an issue. Someone smart mentioned how currency carry trade during current times is like collecting pennies from the highway, when a truck is approaching; it's free money when the truck is slow and a death knell when it picks up speed. Well for the last few months, risk was shunned from the markets (fast truck) and now that that risk is being brought back (truck slows down), the thrill/greed of carry trade might make a comeback leading to a weaker Yen.
• Another key question to ask is, which currency is going to be the counter party to this carry trade? My bet would be either resource rich countries, cheap currencies, currencies with rising interest rates or having all three attributes. My bet would be on the Australian dollar, the US dollar, the New Zealand dollar and of course Chinese Yuan.

At the same time, the Japanese economy's numbers might not suggest a lot of strength.

• As the BoJ is expected to publish its semi-annual report on the economy around the 30th, it might reiterate its April report projection about slow growth in the near future and moderate growth thereafter.
• As the US economy slows down, followed by Europe and then Asia too, capital spending should start to show weakness, especially by all-important exporters of Japanese goods. Capital spending has been touted as one key indicator to watch while looking for a Japanese economy comeback.

So in this framework, I believe it seems pretty remote that the new BoJ Governor Mr. Shirakawa would act as hawkish as some Yen bulls argue, so I would say Yen might be ready for some weakness in the coming weeks.

Comments

[ikkyu]

Greeting,

The USD is a "borrow" currency in the G10 carry basket a la the ETF DBV, due to its currently low interest rate. That is worth noting for when considering currency trends.

Cheers from Osaka,
john