The recent bidding of the Japanese yen (NYSEARCA:FXY) reminded investors of its traditional role as a safe haven currency. Yet, there are more nuanced underlying forces which drive the yen market, indicating that this strength might not last long. The yen is guided by three powerful and equally important forces, namely Japan's international trade flows, differences in interest rates between Japan and the rest of the world, as well as the sentiment of the notorious Mrs. Watanabe, a fictional term coined to represent the average retail Japanese investor. While sentiment is overwhelmingly responsible for driving short-term yen volatility, under periods of global duress like the last few weeks, the other two driving factors, i.e. trade and investment flows, can give rise to long-lasting trends. This practically means that the yen depreciation trend which began after the US election, mainly driven by the increasing yield differentials between Japan and other advanced economies, has not probably ended its course yet. The yen's downtrend is likely to resume itself, sooner rather than later, under the premise that the global reflationary trade extends its presence in global markets.
Bearish And Bullish Macro Forces Fight For Dominance
The yen foreign exchange market is the battlefield of strong opposing macro forces, shaping every major swing in the USDJPY exchange rate. Judging from yen's response to these underlying forces, a possible resurgence of USDJPY uptrend, i.e. a depreciation of the yen against the US dollar, can be expected. As a matter of fact, this expectation can arise naturally from the study of the recent behavior of the Japanese currency.
The sharp increase in the 10-year yield difference between the US Treasury yield and the JGB yield in 2013 dragged the yen down from its historically high prices against the dollar, with Japanese investors dumping yen for dollars to invest in more lucrative US yields (NYSEARCA:TLT). As a result, the USDJPY exchange rate, indicating the price of one US dollar expressed in yen, rebounded strongly from its all-time low level of 75.5 yen per dollar to over 105 yen per dollar, corresponding to a stunning 40% depreciation rate.
However, even after the US-Japan yield differential stabilized in 2014-2015, USDJPY kept its major uptrend fueled by the negative trade flows. The Japanese economy (NYSEARCA:EWJ), at the time, was experiencing unusual trade deficits, receiving more from its exports than paying for its imports. This overturned the current account surplus into a deficit, i.e. the sum of the trade balance and incomes received from and paid to foreigners. Such trade and current account deficits meant that money flowing out of the country was more than money flowing into the economy, dragging the currency down. This negative trade flow dynamic for Japan pushed the USDJPY rate as high as 125 yen a dollar, before eventually rendering the currency an extremely competitive positioning.
In late 2015 the yen has become so cheap in trade weighted terms that Japanese exports could finally revive again. Equally importantly, though, the investment income earned from foreign assets was too high in yen terms. Every dollar earned in foreign assets held by Japanese investors was bringing back more yen, supporting the currency. To be precise, every dollar earned abroad by Japanese firms and investors was producing almost 25% more income in yen, in comparison to early 2014. These forces, combined with the cheapest yen in trade weighted terms in the last 20 years, were enough to overturn the fate of the Japanese currency and make it lead currency gains globally in the first three quarters of last year. The yen broad trade weighted index in real terms, i.e. after taking into account the inflation differences between Japan and its partners, reached a multi-decade low in late 2015, after reversing upwards in the first three quarters of last year.
Then, the election of Donald Trump came and the Great Fiscal Rotation became the name of the game. The expectations of strong pro-growth fiscal policies in the US as well as in other G20 countries, in accordance with a gradual normalization of ultra-accommodative monetary policies, produced a new uptrend in US-Japan yield differentials. The 10-year yield differential between US and Japan reached over 2.5% from just 1.8% in less than three months, pushing the USDJPY rate upwards over 117 yen a dollar from as low as 100 in September. The yen broad TWI also went down again towards its multi-decade lows.
However, this was not the only yield differential that drove yen's depreciation. Sovereign bond yields in most countries picked up in response to the global reflationary scenario, making Japanese investors to revert to other bond markets with juicy yields such as Australia. In this light it is no coincidence that the bilateral rate of AUDJPY, the price of the Aussie dollar in yen terms, spiked ahead of the generalized appreciation of the Australian currency (NYSEARCA:FXA). AUDJPY, in fact, followed closely the bullish reversal in the 10-year Australian bond yields, which started back in September, long before the Australian trade balance turned into a surprising surplus. Japanese capital flows from Japan to Australia powered the frantic rebound in the AUDJPY rate, as Japanese investors were exchanging their yen into Aussies to invest in local government paper.
Source: tradingview.com, investing.com
This regional Pacific yen cross highlights how strong the investment flow factor is for determining the fate of the yen in general. It is in fact so strong that it overwhelms the ultra-competitive valuation of the Japanese currency. The depreciation of the yen in the last quarter of 2016 was realized despite the cheap positioning of the currency and the strong trade inflow that this positioning entailed. In the last year or so, Japan witnessed the highest surpluses in the last six years, meaning that it received some of the strongest trade and income inflows, reminiscent of its good old days of the 80's and 90's! Still, the yen depreciated against these trade and income inflows, as investors aggressively chased higher yields abroad. In simple terms, as Japanese firms were gaining more money from abroad they were investing more of them outside of Japan.
Lately, the USDJPY rate dropped when global jitters about the actual design and execution of Donald Trump's pro-growth policy agenda appeared in fixed income markets. The seeming pause in the global reflationary scenario, drove US long-term bond yields into a consolidation phase, pausing the uptrend in US-Japan yield differential. This was enough to drive the yen upwards, since the underlying trade and current account flows continued to support it.
However, as the USDJPY heads towards the 100 area, global bond yields (NYSEARCA:BWX) keep their uptrend dynamics, as the reflationary signals still dominate the macro backdrop. This shows that while the positive current account forces in favor of the yen drive the currency up, the global case for higher inflation and higher bond yields abroad will soon take the lead in driving the currency down again. Should the global reflationary trade in commodities, bonds, and currencies resume itself assisted by material pro-growth policy steps in the US and China, the USDJPY could easily reach new highs this year and even test its 2015 top of 125+ yen a dollar.
Of course if such a bearish case for the yen materializes down the line, then Japan's surpluses will inflate even more and will at some point overwhelm the investment outflows. This combination might produce a great long-term short opportunity on USDJPY further down the line, assuming of course that the competitiveness gains translate into greater global market shares for Japanese exporters. For the time being, though, the reflationary forces seem strong enough to stabilize the correction in the USDJPY and produce some decent gains in a retest of the recent highs.
Will Mrs Watanabe reap the benefits from another round of yen depreciation which can produce meaningful currency gains from her foreign assets? The probabilities tip in her side, despite the recent doubts raised over Donald Trump's decisiveness to progress on his pro-growth agenda. The global economy is spontaneously accelerating its cycle, even by a moderate pace, even before any tangible fiscal action materializes. Global yields are poised to go upwards and USDJPY to follow suit. It seems, thus, that Mrs Watanabe will still be able to witness the sun rising in her land, at least for quite some time.
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