Riding the yen roller coaster

Riding the yen roller coaster

Equity market volatility and global risk appetites will drive the yen in the near future.

The start of the fourth quarter has been volatile for the Japanese yen (JPY). Japan’s currency swung up and down in the weeks following a change of the Japanese political guard with a new Prime Minister Sept. 26, a fresh plunge in U.S. equity prices in mid-October, and ongoing portfolio adjustments in relation to global carry trade positions (Figure 1).

Fresh concerns about the U.S. economy, centered around housing market woes, helped trigger the October equity sell-off (the 20th anniversary of the October 1987 crash might have played a part, too), which in turn decreased global investors’ appetite for risk — again — and helped drive the yen higher vs. the dollar. It’s like seeing reruns of your favorite television episode. When risk appetite in the global investment community rises, players move back into the carry trade, selling yen and buying riskier, highyielding assets. A decrease in risk appetite, however, sparks an unwinding these positions, which ultimately boosts the yen.

The risk roller coaster
With interest rates at 0.5 percent in Japan, the lowest among industrializednations, analysts say the carry trade is not dead — at least not yet, anyway.

Sluggish growth conditions in Japan, with hints that deflation is still lingering, will likely constrain the Bank of Japan (BOJ) from “normalizing” interest rates anytime soon. As a result, when global investors find a renewed appetite for risk, they’ll likely step back into the carry trade, depressing the yen’s value. However, at the first whiff of volatility, financial market instability, or weakening economic news — especially relative to the U.S. — a massive unwinding would prompt the yen to spike up again.

“Carry trades remain extremely fluid,” says Brian Dolan, chief strategist at Forex.com, a division of Gain Capital. Dolan has noticed an extremely high correlation between U.S. stocks and the dollar/yen pair (USD/JPY). “If stocks are down, the yen crosses are down,” he says. Jamie Coleman, managing editor of Thomson FX Hub, agrees.

“Trading in the yen has almost nothing to do with the Japanese economy and everything to do with the carry trade and people’s willingness to take on risk,” he says. “The carry trade has become the risk barometer. When the market feels risk averse, the yen strengthens; when the market is in a risk-taking mood, it shorts yen aggressively.”

Political instability
Another factor is Japan’s political structure, which is so closely tied to its economy. A political shake-up at the helm of the Japanese government has injected uncertainty into the economic arena, including much-needed fiscal reforms. In mid-September Japanese Prime Minister Shinzo Abe of the Liberal Democratic Party (LDP) was forced to resign in the wake of his party’s devastating loss in upper house elections. However, the new Prime Minister, Yasuo Fukuda, has already lost popularity. A late-October poll by Mainichi Shimbun revealed public support for the new Prime Minister had dropped to only 46 percent, down 10 percentage points from the previous month, just after he hadassumed office.

“Fukuda will face the challenges that bedeviled his immediate predecessor — how to move the economy and growth forward, beat deflation, and curb the recent explosion in public debt, which has reached a point where it will represent a significant burden to future generations,” says Matt
Robinson, economist at Moody’s Economy.com in Sydney, Australia. ”Addressing the government’s budget deficits will require reining in public spending and also reforming the taxation system, including raising consumption taxes.”

Some analysts expressed concern the new Prime Minister may actually be a step backward for the country.

“I worry he is a member of the old school,” says Tony Hughes, managing director of credit risk at Moody’s Economy.com in Pennsylvania. “He has been a minister in LDP government and his father was also an LDP prime minister. There are all these symbolic ties to the old school.”

Japan is known for its extensive system of patronage and backroom deals, which analysts say have included many “bridges to nowhere” — porkbarrel spending designed give political allies lucrative, but unnecessary, public works and business ventures.

“There is a desperate need for reform,” says Hughes. “Japan is increasingly being run by old guys in suits who represent the old politics. I don’t feel confident the problems they encountered in the 80s and 90s will be overcome.”

The growth picture
Japan’s economic fundamentals aren’t especially encouraging. Many economists agree the Japanese economy continues to struggle. The International Monetary Fund (IMF) recently released new projections for global and individual country growth, with percent. Credit Suisse economists lowered their 2008 Japan GDP forecast from 2.3 percent to 1.8 percent. Moody’s Economy.com’s 2007 GDP growth is at 2.1 percent, slowing to 1.8 percent in 2008.

“The Japanese economy has returned to stagnation, with consumer spending and consumer sentiment taking a hit,” Dolan says.

Recent data reveals consumers continue to hold off on spending. Japanese department store sales fell 2.5 percent year-over-year in September, following a 1.4 percent year-over-year increase in August.

Deflation still alive
While economic growth is faltering, inflation remains nowhere in sight. The latest data revealed that yearover- year in August, the core CPI rate had actually declined by 0.1 percent.

“Essentially Japan is still experiencing deflation, and that’s preventing the BOJ from hiking rates,” says David Powell, senior analyst at Ideaglobal in New York. “Japan has not been able to
revive domestic demand very well. Incomes have not been rising along with the tightness in the job market, which constricts consumer spending and is the weakest link in the Japanese recovery.”

Looking to 2008, Moody’s Economy.com’s Robinson does not think inflation will emerge at any significant level.

“High crude oil, as well as higher food prices across Asia, will put upward pressure on consumer and producer prices in the months ahead, eventually feeding into core inflation measures,” he says. “The recent appreciation of the currency will counteract this, dampening any imported inflationary pressures, while the subdued state of the consumer sector will ensure that demand pressures remain too weak to put any real upward pressure on prices. Even if Japan can break from deflation, any rise will be small.”

Monetary policy
These factors add up to a BOJ firmly on hold. The overnight rate in Japan remains at 0.50 percent, the last adjustment a 0.25-percent basis-point hike in February.

The next meeting is Nov. 12-13 (the most recent one was Oct. 31, and rates remained unchanged), but given the sluggish pace of growth and the lack of overall inflation, the market expects the BOJ to leave rates alone into 2008.

However, the BOJ wants to normalize interest rates. If the Japanese economy were to slow significantly or even slip into recession, the BOJ would not have many tools to help jumpstart economic growth with interest rates at such low levels.

“A key decision facing the new administration will be the replacement of BOJ Governor Toshihiko Fukui, whose term expires early next year,” Robinson says. “The politics surrounding
future BOJ actions have become a little more complicated lately. Governor Fukui still appears adamant that a rate rise is required without delay as part of reducing the interestrate differential between Japan and the rest of the world, and thus stemming the outflow of Japanese yen that has been fuelling global liquidity.

“However, the newly appointed Minister of Finance, Fukushiro Nukaga, has urged considerably more caution, implying in a statement recently he would not look favorably upon a rate increase, and that the cost of borrowing should not be pushed up until deflation is a distant memory,”
he adds.

G7 Meeting
Prior to the G7 confab on Oct. 19, some European finance officials had been complaining about the high level of the euro (EUR), which led some market analysts to speculate the G7 would adjust its language regarding exchange rates. However, the recent G7 meeting saw little in the way of fresh news or direction for global currency market traders.

“In their statement, Ministers remained silent on the recent weakness of the U.S. dollar, restricting commentary to the previously agreedupon line that currency values should be determined by market forces” says Robinson. “The release of the G7 communiqué from Oct. 19 undermined the position of any currency trader betting on a deviation in the long-standing U.S. policy to refrain from supporting the currency’s value.”

U.S. housing and the broader economy
Many questions remain regarding the state of the U.S. housing market recession, including how much worse will it get and what the impact might be on 2008 U.S. economic and global growth.

Ideaglobal economists warned in their Global Forex Outlook Q4: “In the event the housing correction is much more marked and causes a U.S. recession, USD/JPY could see a serious test of 105, below which we think it may get uncomfortable for the Japanese. Politics will make it difficult for the BOJ to consider intervention and at the most they could slow the move rather than reverse it.”

Yen outlook
Despite the recent dollar/yen volatility, the pair has remained within a roughly 118.00/112.00 range since late August (Figure 1). With the yen remaining captive to the whims of global carry trade players, movement in the Japanese currency will remain dependent on overall levels of market volatility and global risk appetites.

For now, currency strategists agree that economic and political fundamentals will have little impact on the overall action of the Japanese currency.

“It looks like we’ve shifted into a 113-118 range,” says Thomson FX Hub’s Coleman. “And 118 has become a formidable barrier. I’d be selling rallies in dollar/yen and euro/yen.” Forex.com’s Dolan has been monitoring the CBOE Volatility Index’s (VIX) correlation with the yen carry
trade (Figure 2).

“The VIX had been averaging around 12-15 in June [as dollar/yen was rallying into the 124 region],” he says. “At the peak of the market turmoil in August, the VIX soared to 37.5 as yen carries were dropped.”

In early October, as volatility retreated, the VIX dropped back to the 15-18 region. However, on Oct. 19, the VIX had surged above 22 when the U.S. stock market turned sharply lower.

Dolan suggests forex traders monitor the VIX as a potential timing tool for yen carry trades.

“On moves above 18-20 in the VIX, it might not be a good thing to be looking at the yen carry trade,” he says. “It is very much a real-time situation. If you’re trading the yen, you’ve got to be watching the equity markets.”

Implied volatility in three-month dollar/yen options is another measure forex traders could monitor. Ideaglobal’s Powell has been watching this indicator in recent weeks, noting a recent summer implied volatility low at 6.7 on July 20. However, in mid- August, as the dollar/yen pair retreated below 112.00, implied volatility soared to 14.9. As of Oct. 18, implied volatility stood at 9.1.

“We are still in a period of elevated volatility, although it has calmed down from the August peak,” Powell says.

Forex traders are well aware that low volatility is ideal for successful carry trades. Otherwise, price spikes can wipe out the profits from bullish interest rate differentials.

“We expect volatility to remain elevated between now and year-end, which should keep the dollar/yen below 120.00,” Powell says.

Ideaglobal forecasts the dollar/yen at 112.00 at the end of 2007, and at 110.00 at the end of the first quarter 2008.

“If there is further turbulence in U.S. equity markets it would not be a good time to be long the dollar/yen,” Powell notes.


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