FYI | Sep 16 2010
By Greg Peel
There's a bit of sport in watching the Aussie dollar tick onward ever upward, given it engenders a sense of pride in the average Australian that we are, in a sense, sticking it to the Yanks. But given Australia's total reliance on the export of commodities, a strong Aussie dollar is actually not a good thing per se. Just ask our tourism industry – in-bound tourism is effectively an export.
Japan has no commodities of its own to export, so it's a big importer. One might assume therefore that a strong yen is good for Japan as it makes iron ore and coal cheaper. But that iron ore and coal is turned into Toyotas for export, and the second (almost third now) biggest economy in the world is only so because of exported Toyotas, Sonys and the like. Thus a too-strong yen is bad. Very bad.
It's hard to see why the yen could ever be strong, given the Japanese economy has been in deflation for twenty years, but then one must remember that currencies are not absolute but relative. If the yen is “strong” it is only because another currency is “weak”, which means that if another currency becomes weak, the yen becomes strong whether Toyota sales are good or bad. If we recall that then Fed chairman Alan Greenspan cut the US cash rate to an unprecedented 1% in 2004 in response to the tech-wreck and 9/11, we can understand why 2004 was the last time the Bank of Japan was ordered by the Japanese government to intervene in free floating currencies markets and put a cap on the yen.
Then the yen was trading at around 104 to the US dollar. Yesterday it hit a 15-year high at around 82 to the dollar. [Yen is quoted inversely to the Aussie as yen-to-the-US-dollar rather than US-dollars-to-the-yen, which is why lower numbers actually imply a higher yen.]
At that point the BoJ intervened, selling an undisclosed amount of yen. Often when a central bank intervenes to cap a currency it will in turn issue bonds to effectively borrow from the market the money it has just sold. This is known as “sterilisation”. But it is apparent the BoJ has not yet sterilised its sales and no one expects it will. The BoJ has applied quantitative easing, meaning it has simply “printed yen” and sold it.
As we know, QE is used to provide monetary stimulus (make money more available) to an economy when interest rates have already been cut to near zero. Japan's cash rate is currently 0.1% and it has not reached single digits since the 1990s.
This longstanding low interest rate regime has meant Japanese investors have had to look elsewhere for a return on their retirement funds, finding Australian and New Zealand high interest rate bonds very attractive, for example. But it has also meant that hedge funds in other countries can, when their own cash rate is high (the Fed cash rate was 5.25% prior to the GFC) borrow in yen and invest in similar assets, or better still, high-yielding risk assets.
This “carry trade” always comes with a risk, being that the currency differential will move against you and your profits will be wiped out (maybe even into losses). But so entrenched has been Japan's deflation and resultant low interest rates for the past decade, the currency window has never really closed. There has simply been the odd scare, such as in 2004.
Given the GFC meant a rapid rush out of risk assets and a retreat to safe havens like gold and the US dollar, the yen naturally appreciated at this time as yen borrowings were unwound. But even as the initial panic has subsided, the yen has just kept rising, and rising, and rising.
There are several reasons why, but they can all realistically be summed up as “the US dollar”, and just how tenuous the world's reserve currency has become.
Firstly, the Japanese cash rate is only 0.1% but its inflation rate is negative, meaning the real overnight rate is more positive. The US cash rate is now a range of zero to 0.25%, but inflation is positive so real rates are actually negative. This hasn't stopped the world flocking to short-end US Treasuries for protection, but the reality is Japanese government bonds are now actually more attractive. The world's second biggest economy is also seen as a “safe haven” outside of the US, gold, and the Swiss franc.
Switzerland has been systematically intervening in its currency since 2009.
Secondly, not only are JGBs thus attractive in their own right, but the yen is seen as a currency through which those with big budget surpluses, such as the BRICs, can diversify away from overexposure to a fragile reserve currency. The primary candidate for diversification was previously the euro, but look what happened there. So JGB buying has been the new global pastime, and each purchase pushes up the yen.
Thirdly, if any US hedge fund does want to increase its risk exposure in this current market then it no longer needs to take a currency risk and borrow in low-rate yen. It can just borrow in low-rate dollars and cut out all currency risk. So there has not been a downward carry trade force on the yen in the last couple of years as there was pre-GFC.
The BoJ's move to intervene in the yen yesterday came as no surprise to anyone, other than in how long it took the central bank to finally make the decision. And in discussing the move in reports today, economists agree that yesterday's activity was probably just the beginning of a longer intervention program. And to do so without sterilisation, meaning to implement QE, comes as no surprise either.
Economists do not believe, however, the BoJ will do anything more than cap the yen. It will simply attempt to not make the situation any worse for Japanese exporters rather than try to improve conditions artificially by actually pushing down the yen. This was a unilateral intervention, conducted without the support of the Fed or ECB or anyone else in counter-buying dollars or selling euro which is often the case in crises (such as the GFC, in which the dollar was collectively supported by everyone including the RBA).
And it is hardly a surprise the BoJ received no support. While some economists suggest the US and Europe will have responded with a resigned shrug, some journalists suggest Europe will be wincing and the more protectionist of US Democrats will be quietly ropable. One must not forget that God gave only America the right to prosper – not anyone else.
The reason a capped yen is bad news for Europe and the US is that all three manufacturing exporters are chasing the same, now much reduced, buying pool. If it wasn't bad enough for the US that the euro crashed on sovereign debt problems, making German exports comparatively cheaper, now Japan is trying to stop US exports being more competitive on a weaker dollar. And in Europe's case, cheaper German exports are about the only thing holding up the entire eurozone at present.
But while the G3 plays push me-pull you, the East (of which Australia is a surrogate member) quietly sails on. The risk to Japanese investors is that a rising yen will negate their higher-yielding offshore investments. Now that they can feel safe the yen is capped, currency risk is all but taken out of the equation. In theory, risk assets should benefit. And even US hedge funds can feel safe in re-applying yen carry trades should they so desire.
From an Australian export perspective, selling the yen means buying the US dollar which means a stronger US dollar which means a lower AUD/USD. It means a higher AUD/JPY, but then the world's commodities are traded in USD.
Global stock markets had already been rising in September, and a capped yen is actually further encouragement given it re-encourages risk trading.
But then looking underneath it all, we now have the ECB and Japan applying QE one way or the other and the US is expected to probably being joining in again soon. Indeed, BoJ currency intervention might even give the Fed a shove. The G3 is in a race to save each and all of their stagnant economies. That can't be good, particularly if we look to what might happen down the track.
