Since late 2012, the yen has fallen nearly 40% as the Bank of Japan (BOJ) has launched an all-out war to devalue its currency. The forces that would likely drive this push were no mystery. As outlined on Financial Sense in June 2012 (see Massive Japanese Debt Monetization Is Coming, Yen to be Devalued), Japan's ticking time bomb of debt was coming head to head with its demographic time bomb, which forced the BOJ to act. This can be seen in the handoff below as aging Japanese citizens began to sell their debt holdings while the BOJ ramped up.
The launch of quantitative easing (QE) in Japan late in 2012 opened the door for the yen-carry trade to be revived again as the following article from early 2013 highlights:
As confidence returns to global markets, investors appear to be using the cheap yen once again to fund investments in risky assets - a trade that is likely to give the battered Japanese currency another boot lower in the months ahead, analysts said…
This backdrop coincides with a sentiment shift in financial markets, with investors increasingly moving into more risky assets.
"The yen is regaining its ground as a funding currency," said Jesper Bargmann, head of G11 currencies at Royal Bank of Scotland in Singapore. "Sentiment has changed in markets, pretty much since January 1. Risk appetite has returned, there's increased confidence and a search for yield, so the yen seems to be suffering as a result of that," he said…
A carry trade is when investors borrow in a low yielding currency, such as the yen, to fund investments in higher yielding assets somewhere else…
A weakening currency is central to the carry trade since it means that investors have less to repay when they cash out of the trade.
I don't believe it is just coincidence that the USD surged relative to the yen late in 2012 to early 2014 at the same time the U.S. stock market soared as shown below.
Given the rather dramatic decline in the yen relative to the USD over the last two years, it makes sense to reevaluate how much more downside the yen has and what the implications would be should the yen rally in 2015. One way to analyze currency movements is based on interest rate parity (click for definition) in which currency exchange rates should move in line with the differential between country interest rates. As shown below, this theory more or less works in which the USD/JPY exchange rate tracks the difference between U.S. 10-year interest rates and Japanese 10-year interest rates. However, there are times when the two diverge and these large divergences eventually get unwound rather sharply (see yellow shaded boxes below). We've seen three cases in recent years with one in 2010, 2011, and one in 2013. In all of these, the JPY/USD exchange rate got the direction right and the interest rate differential played catch up. We are currently experiencing our fourth major divergence in recent years in which the USD has rapidly appreciated relative to the yen and yet U.S. long-term interest rates have not risen relative to Japan; in fact, the interest rate differential has declined (see red shaded box).
This divergence can be unwound by the yen rallying relative to the USD and the USD/JPY exchange rate falls, or U.S. long-term interest rates can rise relative to Japanese to close the gap. Which event occurs in the months ahead (yen rally or U.S. interest rates rally) will have very different outcomes for the market. If the yen rallies and the USD/JPY exchange rate falls, the yen-carry trade will start to unwind and with it one element of market liquidity. As shown above, when the USD rallies relative to the yen we tend to see strong U.S. stock market returns and so if the USD falls relative to the yen we could see some market weakness ahead. In fact, if the yen should decline we would be witnessing a backdrop that we haven't seen since 2012: no QE from the U.S. Fed and a strong yen - two major liquidity supports for U.S. financial markets for the last two years.
We've seen how QE has tended to float the U.S. stock market higher and when QE was turned off the stock market would stumble. However, the Fed embarked an open-ended QE late in 2012 such that QE was running for all of 2013 and the bulk of 2014 and coincident with this time frame was a massive devaluation of the yen. The S&P 500 soared during these times in which both added liquidity to the system, which is shown by the green shaded regions below, while the yellow regions show only an expansion in the Fed's balance sheet. We've had a lot of stimulus over the past two years coming from Fed's QE and the yen-carry trade. We know the Fed's QE is over, and should we also lose the yen-carry trade, we could be in store for a bumpier ride than we've seen recently.
As mentioned above, the divergence between the USD/JPY exchange rate and the interest rate spread between the U.S. and Japan can be resolved in two ways, and my inclination is that we see the USD weaken relative to the yen in the weeks and months ahead. Why? One reason, as shown above, is that the USD/JPY exchange rate is bumping up to resistance at the ~$120 level, which is the 2005-2007 resistance zone. So, from a technical standpoint it's hard to see the USD appreciate further without some digestion and consolidation.
Secondly, from a purchasing power parity perspective (click for definition), the yen is at its cheapest valuations relative to the USD since the middle 1980s. Using Bloomberg's purchasing power parity function with the Consumer Price Index (CPI), Producer Price Index (PPI), and the annual OECD estimates, the yen is between 15% to 34% undervalued relative to the USD. Given the multi-decade lows in yen valuations, a further depreciation of the yen appears unlikely.
Assuming for the sake of argument that the yen does cool off in early 2015, what can we come to expect? As mentioned above, the yen-carry trade has been associated with positive stock market returns and so an unwinding of the yen-carry trade in which the yen appreciates relative to the USD could see a weaker stock market, particularly coupled with the removal of U.S. QE. Secondly, we could also see a pick up in overall investor anxiety in which safe haven assets like gold benefit. Both the yen and gold peaked in 2011 and accelerated their down falls late in 2012. Should we see stabilization in the yen ahead we could see stronger gold prices in 2015.
Also associated with yen strength is a pickup in volatility as the yen-carry liquidity tide goes out. This is shown below with the USD/JPY exchange rate shown inverted along with the Volatility index (VIX) with periods of yen appreciation shown by the yellow shaded regions.
In my last article (click here), I made the case that the U.S. was not at risk of slipping into a recession and the hallmarks of a bull market top were missing, and thus argued the weakness experienced in December was a buying opportunity. The market has since rebounded sharply in recent days and looks like it will experience the seasonal Santa Claus rally into year-end and we could see some strength spill over into 2015.
While I still do not see the signs of a recession or a bear market on the horizon, that is not to say we can't see a pickup in volatility or market gyrations in the year ahead. In fact, I think the most bullish theme one can be on in 2015 is a pickup in volatility with the removal of QE and a possible yen-carry trade unwinding.
As highlighted in this article, there is a large divergence between the USD/JPY exchange rate and their associated interest rate differentials, and my belief is this divergence will be resolved by the USD weakening relative to the yen in the weeks and months ahead. Should this occur we could see a rough start to 2015 with stocks weakening while gold rallies. The biggest theme I see for 2015 is a pickup in volatility and the best advice for that kind of climate is to stay humble as the market whips around here and there and confuses bulls and bears alike, and to stay nimble as market volatility always creates opportunities.