Currency of the Month – Japanese Yen Improving Fundamentals or Head-Fake?

A funny thing happened on the way to the globally coordinated NIRP (negative interest rate policy) extravaganza, and the Japanese yen appears situated front and center to the mystery. At the end of January 2016, the Bank of Japan (BOJ) announced it would double down on its monetary strategy, applying a negative rate of 0.10% on excess reserves for financial institutional depositors.1 The policy move, joining the European Central Bank’s (ECB) move to NIRP in June 2014,2 requires depositors to actually pay for the pleasure of keeping excess reserves deposited in its banking system.

In theory, lower yen values should make the country’s goods and services more attractive to importing countries, thereby supporting Japan’s manufacturing activity and economic growth. Negative interest rates should have presumably driven currency investors running for the hills, placing downward pressure on the value of the Japanese yen as bonds are sold and deposits are withdrawn.

Paradoxically, the Japanese yen has actually appreciated relative to the U.S. dollar since the end of 2015, when one U.S. dollar could purchase about 120 yen, as compared with more recent conversion rates at just under 110 yen for each U.S. dollar (Figure #1). As the Sicilian criminal mastermind, Vizzini, famously repeated throughout Rob Reiner’s classic movie, The Princess Bride, “Inconceivable!”

Fig. #1
USD/JPY Exchange Rate (01/2015-05/2016)


Even The Best-Laid Plans Go Awry
The BOJ has been using interventionist monetary policies to stimulate the Japanese economy as far back as the early 1990s, when the central bank began aggressively lowering interest rates (Figure #2) in response to collapsing equity prices and real estate asset values resulting from the bursting of Japan’s liquidity bubble.3

Fig. #2
Bank of Japan Discount Rate (01/1988-01/2016)

Source: International Monetary Fund, Interest Rates, Discount Rate for Japan© [INTDSRJPM193N], (retrieved from FRED, Federal Reserve Bank of St. Louis, May 16, 2016).

In 2012, Prime Minister Shinzo Abe introduced the most aggressive response to fighting Japan’s slow growth and deflation, launching a three-pronged strategy involving doubling the monetary base, easing monetary policy, and implementing structural reforms.4 Frustrated by the Japanese economy’s continued deflation and slow growth, Abe’s recent implementation of negative rates on excess deposits doubles-down on the BOJ’s unconventional monetary policies, helping to drive yields on the Japanese government’s 10-year bonds to below 0 percent (Figure #3).

Fig. #3
10-Year Japan Government Bond Yield (01/2012-05/2016)


Motivating a bond investor to purchase a 10-year government note with an expected yield below 0 percent is a tricky task left only to the skills of a most gifted marketing artist, which may help explain why the Japanese central bank currently owns one-third of the entire JGB market.5 At current rates, the BOJ will undoubtedly be the primary purchaser of government bonds, perhaps moving on to equities once bond selling has been satiated. Clearly, this monetary path does not bode well for the relative value of Japanese yen.

The Paradox Of A Strengthening Yen
Despite best efforts by the Japanese monetary authorities to weaken Japan’s currency, the yen has stubbornly appreciated against the U.S. dollar, undermining the BOJ’s initiatives to reduce borrowing costs and stimulate the economy.6 A number of theories exist as to why the yen has appreciated against the dollar in such an admittedly counterintuitive environment.

One reason may be an ongoing unwinding of a popular carry trade in which institutional investors had purchased Japanese stocks while shorting the yen, assuming that the BOJ’s injection of liquidity would simultaneously generate returns for equities while reducing yen levels.7 As the carry trade has reversed, investors have been closing out long positions in equities and concurrently covering short positions in the yen, ostensibly leading to appreciation in the currency.

Market observers also view the concurrent timing of the U.S. Federal Reserve’s more recently dovish outlook on interest rates as providing support for the Japanese yen. After raising interest rates in December 2015, the Fed has eased back on the potential rate of change for higher interest rates in the U.S., in light of undeniably weakening global economic indicators.8 Recognizing that currency trades are a relative investment strategy, the Fed’s move may have removed growing investor enthusiasm for higher relative yields from the U.S. dollar, and consequently removed long positions in the dollar.

One of the more intriguing theories attempting to explain the recent strength in the Japanese yen has been accounts of a secret deal made at the G-20 meeting in China in February 2016, designed to weaken the U.S. dollar relative to the yen, renminbi, and euro. The theory, characterized as the Shanghai Accord, suggests a coordinated global effort to reduce the value of the U.S. dollar, helping to calm global financial market volatility by driving global stock markets, emerging market assets, and commodities higher.9 Since the Shanghai meeting, officials from China, Japan, and the United Kingdom have each taken actions to promote global liquidity, including the expansion of domestic credit and corporate bond purchases from Japan and the European Union, while the U.S. Federal Reserve has scaled back on its plan for future interest rate increases.10 The result has been downward pressure on the U.S. dollar, and upward pressure on most global currencies, including the Japanese yen.

Outlook For The Japanese Yen
Astute readers of the Daily Pfennig® newsletter will recognize that none of the aforementioned explanations for a strengthening in the yen are indicative of an improving economic environment for Japan. With no authority regulating these types of coordinated accords, save for the International Monetary Fund (IMF) jawboning the Japanese central bank to avoid further depreciation of the yen, compliance with a Shanghai Accord will be as strong as the will of the BOJ to fulfill its terms.

Recent statements from the BOJ would seem to indicate that any motivation by the central bank to comply with the alleged accord could already be waning, as evidenced by BOJ Governor Haruhiko Kuroda’s more recent comments alluding to an even further expansion in monetary initiatives or direct currency intervention in order to reduce the value of the yen, the linchpin of Prime Minister Abe’s program of stimulating the Japanese economy.11

Where does this leave the Japanese yen? Frankly, in the same situation the currency has been prior to the most recent period of strengthening: a slow growth, deflationary economy with high trade deficits and ever-expanding government debt levels. As such, one may want to keep an eye out for a “Yen Rally” head-fake, which may eventually turn into more of a headache for currency investors.

Until the next Daily Pfennig® edition…

Chuck Butler
Managing Director
EverBank Global Markets Group