The yen's (NYSEARCA: FXY) unabated strength continues to baffle markets in this environment of negative interest rates and QQE. It has been almost a year now that the yen is rallying, and over this period, it has gained more than 12% against the US dollar. So sharp has been the rally that it has left markets searching for plausible explanations, particularly when the BOJ sounds confident of achieving its policy objectives. The consensus emerging is the BoJ (along with other DM central banks collectively) has lost the plot as markets have now called its bluff.
As Bank of America Merrill Lynch writes in one of its FX strategy piece via FT's David Keohane:
"…market reaction to central bank policies has changed substantially. Five G10 central banks have surprised markets with their policy easing this year, namely BoJ, ECB, RBNZ, Riksbank and Norges Bank, but their currencies are now stronger… equities are also down for the year in these countries, which raises questions about the effectiveness of their monetary policies."
The dominant narrative in FX now is:
- Central banks are understanding the limits of competitive devaluation (also called 'currency wars').
- Central banks can't continue to loosen monetary policy forever, and this is the year that some of them may be forced to stop.
- The market's focus has now shifted to speculating on which central bank will quit easing monetary policies first, feels BofAML.
- We are in a new FX regime where DM central banks seem to have lost their power to influence the direction of currency movements.
- In particular, the BOJ has realized its folly that negative rates have not only failed to engineer JPY weakness but in fact, have done the opposite of what was expected.
Thus, the growing belief in the market is central banks, in particular BOJ and ECB, have to give up competitive devaluation - as it is proving to be a zero sum game - and watch from the sidelines as currencies correct course.
Why has USD/JPY defied common economic logic?
Well, the short answer is that it hasn't. A look at the picture of capital flows in Japan makes it clear why the yen has strengthened so much.
Let's start by looking back at recent history. USD/JPY fell from below 80 in mid-2012 to 125 in mid-2015, weakening by 50% in the space of three years. It was the time when Abenomics was viewed as a buy equities and sell yen trade, and it worked out perfectly.
During this period, Japan's current account has almost consistently been in surplus. Not only that, the surplus has kept increasing, as can be seen in the chart below. In fact, February marked the 20th consecutive month of current account surplus for Japan.
Source: Japan Ministry of Finance
Such a high current account surplus needs to be matched by capital outflows from the country. However, as can be seen from the second chart, capital has mostly flowed into Japan, particularly in the last couple of years. Remember, this happened in the backdrop of quantitative easing and negative interest rates.
Source: Japan Ministry of Finance
Therefore, while the currency weakened in response to BOJ's policy, it had to reverse at some point due to the impact of the current account surplus coupled with capital inflows. A similar trend is evident in the performance of Japanese equities during this period, which continued its surge until mid last year before correcting sharply.
A contrarian view on USD/JPY
The simple rule in markets is after a rally, we should expect a correction. If the rally is sharp, so should be the correction. However, is it just a correction? Or has the BOJ lost control? Is this a new regime in FX where market reaction to central banks has changed dramatically?
We believe the reversal in USD/JPY is a correction driven by safe haven flows. This correction seems to have mostly run its course. Our thesis is based on the assumption that the BOJ will continue with its loose monetary policy stance, irrespective of what happens to the yen. As I mentioned in an article last month, the BOJ firmly believes its monetary policy has created the desired impact in the last few years, and remains confident of achieving its inflation objective.
Abenomics needs to be viewed from the right perspective. While a weaker yen was always a desired outcome, it was not the ultimate goal of monetary policy. As Kuroda puts it in a speech last month:
"The key aim of this policy is to drive down real interest rates, which is the main transmission channel of QQE… QQE puts strong downward pressure on nominal interest rates across the entire yield curve through massive purchases of Japanese government bonds (NYSEARCA:JGBS-OLD). The (resultant) decline in real interest rates boosts business fixed investment and housing investment through a decline in interest rates on business and housing loans."
In other words, the BOJ is making the distinction between monetary policies aimed at lowering real interest rates that have a weakening effect on the currency, and those that are directly aimed at devaluing the exchange rate. Through quantitative easing, the BOJ is telling us it is pursuing the former. This raises an important question. Would the BOJ ever take a direct aim at the yen? With some more yen hardening, things are surely going to get interesting.
Still, QQE will continue uninterrupted, and if anything, will increase if the BOJ buy equities. It is a topic for another day, but in the near future, fighting the BOJ is going to prove futile. Capital flows will ultimately reverse once risk-on sentiments kick in and investors resume their search for yields.
But why isn't it happening?
Well, mainly because the move has been so sharp and so one-sided in recent times. The sheer momentum is USD/JPY tells us there has to be other forces at play than simply capital flows.
The other key force at play seems to be currency de-hedging by foreign investors in Japanese equities. These investors hedge their currency risk through a short position in the yen. The sharp fall in Japanese equities would have forced them to unwind their currency hedges in proportion with the loss in their equity portfolios, (i.e. to maintain hedge ratios ). As JPMorgan put it (again via FT's David Keohane),
"…overseas investors who own Japanese equities but do not sell, are only engaged [in] the partial unwinding of the FX hedge which boosts the yen (point 3 above). And this yen flow can be very big. Overseas investors owned $1.7tr of Japanese equities at the end of last year. The value of these holdings in local currency terms declined by $288bn YTD. This means that overseas holders of Japanese equities could have unwound up to $288bn of FX hedges YTD in order to align the size of their FX hedges to the reduced value of their Japanese equity holdings."
Needless to say, it is an important channel through which moves in USD/JPY are intensified irrespective of the direction of capital flows. It also means that capital inflows influence the yen not only directly but also indirectly.
So, what does the future have in store for USD/JPY?
As is always the case, following a correction, prices resume their move in the original direction. If you believe, like we do, that there will be no let off in the BOJ's policy stance, that US interest rates will continue to rise albeit at a modest rate, and that safe haven demand will ultimately reverse in the foreseeable future, then this correction in USD/JPY will eventually be over.
Does that mean we are going to see levels of 125 on USD/JPY soon? Probably not. Although the currency pair should move in that direction in the foreseeable future, there are limits to how far it can devalue. Especially, if the currency in question is the yen and it is still 35% lower than where it was when Abenomics began.
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.