Guest Commentary: Why Yen Weakness Is Not Being Caused by “Currency War”

Despite recent reports, ongoing weakness in the Japanese yen could be caused largely by global risk trends, trade balances, and prevailing sentiment on the part of FX traders, and not the popular central bank “currency war” scenario.

(Continued from Part 1)

Funding Currency
The funding currency is not a primary indicator for FX rates, but the criterion follows logically the other five. Since 2007, the U.S. dollar has been the funding currency for margin and carry trades, while the current account countries (Japan and Switzerland) were used as funding currencies until 2007 during the U.S. real estate bubble.

An example for margin debt is obtaining credit by handing in U.S. government bonds as collateral and using the funds for riskier investments, either in a local or foreign investment currency. This margin debt is considered to be nearly risk-free because the Fed was expected to destroy the purchasing power of the dollar via inflation. As a result, a weaker dollar was expected.
The Japanese Ministry of Finance (MoF) wants to achieve higher inflation, essentially a destruction of the yen’s purchasing power. With some improvements in the U.S. housing market and lower risk aversion, the yen is now the preferred funding currency.
A funding currency typically appreciates when stock and commodity markets fall, and vice versa, albeit there is one small difference: while the yen shows clear reverse movements against stock markets, the U.S. dollar exhibits more inverse behavior against gas and oil prices.
Currencies in a boom phase of the credit cycle—like the Swiss franc—cannot be funding currencies, at least as long as the European periphery does not exit the bust phase. Japan, however, is the ultimate funding currency, because there is no sign of a boom, and thanks to weak demographics, interest rates seem to be bound to zero forever.

Algorithms and Economic Data
Trading algorithms (algos) follow visible principles in daily movements of FX rates. Day-to-day behavior of currency and stock market movements reflect algorithmic rules that are common among major investment banks and have already been valid for decades. These rules are:
The market is efficient, which implies that current valuations are correct
Good or better-than-expected data leads to improvements in the concerned currency/market; and weaker data to a weaker currency/market
The movement is adjusted for historical volatilities; e.g., the EUR/JPY movement is far stronger than EUR/CHF movement
Currencies of countries that are in the boom phase of the credit cycle typically appreciate with good economic news, no matter from where the news emerges. Countries that are currently in a stronger boom phase are Germany, Norway, Switzerland, and some emerging markets. Lately, the United States has shown some indications of boom and rising real estate prices, while China and other emerging markets show slower growth. Both the potential U.S. boom and weakness in China are reasons why Australia, New Zealand, and even Canada seem to be at the end of their long-lasting boom phases, as U.S. funds leave the countries and head back to the States
Currencies with a strong financial position and those with current account surpluses appreciate with bad economic news
Different indicators may show diverting tendencies: while Switzerland is in a boom phase of the credit cycle, it is still a country with a strong financial position and current account surplus. This combination of three major factors led to a strong revaluation of the Swiss franc between 2008 and 2011
FX rate appreciation triggered by capital inflows often leads to more investment, which boosts growth. If the FX rate does not rise too much and when exports are not very price-sensitive, then this is not a problem for the country concerned. It may even lead to a boom phase of the credit cycle. Examples are Switzerland since 2008 (appreciation of the CHF), Ireland between 2000 and 2007 (appreciation of the euro), and Australia from 1992 to 2011.
But also in the short term, there is a certain virtuous circle: good news is followed by better business and consumer sentiments, which again helps to achieve better economic data. On the other side, bad sentiment follows bad news, which again causes economic data to become worse…a vicious circle.

The typical backstop of all improvements is seen in oil prices and inflation. Rising oil prices cause risk aversion to increase and often stops U.S. expansion. Central banks try to limit inflation and hike interest rates with the effect that investments are reduced and boom phases end. In recent history, busts of boom phases have mostly been caused by central bank tightening and increased interest rates.

On the other side, central banks try to create virtuous circles with lower interest rates and quantitative easing. According to the IS-LM model, these central bank-induced artificial virtuous circles are neutralized after 6-12 months, in the “mid-term” by rising inflation.

Asian Bloc vs. American Bloc
The differentiation into the Asian bloc and American bloc is also quite important for price movements driven by algos. The most important countries for economic news are the United States and (recently) China, thanks to their high total spending and strong growth.
Better-than-expected fundamental data in China leads to a weaker dollar—even against the yen—and to higher commodity prices and stronger currencies in the Asian bloc, especially the “bullish” ones, AUD and NZD.
Good or better-than-expected data in the United States leads to a stronger USDJPY and stronger stock markets. In phases when the USD is the principal funding currency, “bullish” currencies of the American bloc appreciate, like the Canadian dollar and the Mexican peso, but also the Swedish krona (SEK). SEK is strongly related to technology and stock markets and often moves with the American bloc.
In phases when the U.S. dollar is the investment currency and Asia is weak, this can lead to irrational exuberance. An example is the Asia crisis in 1998, accompanied with strong U.S. growth and the ensuing dot-com bubble. The investment environment of 2013 resembles that of 2000: China and other emerging markets have weakened, while the U.S. housing market has recovered.
Weak or weaker-than-expected data in the United States leads to appreciation of the “bearish” currencies of the Asian bloc, namely, the JPY, Singapore dollar (SGD), and CHF (thanks to a big trade surplus with Asia). Weak or weaker-than-expected data in China leads to appreciation of the “bearish” currencies of the American bloc, which until recently was the US dollar.
The euro is somewhere in the middle. Germany’s DAX Index, and even more the MDAX, is driven by machinery exports to Asia. German stocks and the Swiss franc belong to the Asian bloc, and they rise with commodities and Chinese growth. The European periphery, however, loses relative competitiveness when Asia becomes stronger and oil prices and inflation increase, causing fears of a global recession to augment. As a result, peripheral bond yields move upwards. The extreme was reached in the inflationary and potentially recessionary scenario in August 2011. Therefore, the periphery belongs to the American bloc. Their bond yields decrease when the situation in the U.S. improves.
A common error is to associate the AUDUSD exchange rate with stock markets and not with commodities. Despite the recent strong correlation during the Chinese growth phase, since 2008, the weak Aussie during the dot-com bubble is the most prominent counter example.

Undeniable Impact of FX Traders
Foreign exchange traders use these virtuous and vicious circles to follow trends in foreign exchange markets. Elliott Wave theory is a more sophisticated form of explaining these circles. Often, FX traders and algos “overshoot” in that they let an exchange rate rise or fall very strongly in a short period so that exports and the current account balances of the concerned country are strongly affected over a longer view. The result is that currencies that overshoot need to undergo a “trend inversion,” or trend in the opposite direction.

FX traders rarely, if ever, hold positions for a long time, and the closing of positions/profit taking accelerates the inverse trend. There is one exception to this rule: namely, when FX traders are carry traders that use big interest rate differentials via swap rates.

The Distortion of Fundamental Data
FX trading can be thought of as being similar to “Groupon” deals, because often, traders follow a master that indicates where the trend is going. Followers imitate the master’s strategy, even if later FX rates get completely distorted from fundamental reality in a short period of time (though I am not recommending the imitation of this strategy).
This is exactly what happened in July 2012, with the strong depreciation of the euro to 1.20 USD, and in January/February 2012, with a strong appreciation to 1.36 and more. Thanks to reduced risk aversion and verbal intervention, the euro rose from 97 to 125 yen in only 6 months. Japanese cars are now 28% cheaper than German ones. While the Japanese take profits from lower production costs with deflation over many years, Germans see inflation, and therefore, higher costs. (Read more about the effect of inflation/deflation on productivity on SNBCHF.com.)
Fundamental data, especially current account balances, have not changed very much in these six months. Typically, the world in terms of current account balances remains mostly the same. An inversion of credit cycles also happens rarely, and the latest inversions were Lehman and maybe the recent upwards trend in U.S. housing, still to be confirmed in the U.S. driving season. Economic data just fluctuates a bit with changes in FX rates and far more with economic and external shocks like Lehman or the 2011 Japan tsunami.
One of the leading FX experts is Ashraf Laidi, who recently told his followers that yen short positions should come back to 2007 levels. He forgets that for such a position, a huge carry trade differential must exist. In 2007, the Fed Funds rates were at 5.50%, and now they are 0.25%. But Laidi has long understood that risk aversion is key to the yen’s movement.

Guest Commentary: The Return of the Yen Carry Trade?
Source: Ashraf Laidi (AshrafLaidi.com)

Traders often have short memories. They replicate recent developments into the future. One example is that in 1999, after the Asian crisis, everyone bet on a Japanese recovery. The yen was the strongest-performing currency, even if the Japanese actually needed to still deleverage from their housing bubble for another 10 years or more.
The recent appreciation of the euro shows that traders remember the strong euro from the year 2011 that was driven by strong Chinese construction and investments and the exports of German machines to China in the absence of European austerity.
In the meantime, however, Chinese expansion has slowed down, austerity reigns, and the bust period of the credit cycle for 65% of the euro zone population has started. Real estate prices in Southern Europe, and also in France and the Netherlands, are falling. Only Germany, Finland, and Austria (together 35% of euro zone population) are in a boom phase.

Why the Currency War Is Not the Main Driver of the Weak Yen
The main reasons for the recent debasement of the yen are, in our opinion, the reduced risk, the presumed entry of the United States into the boom phase of the credit cycle, and the short memories of traders. The government of Japanese Prime Minister Shinzo Abe has quickly understood this development and helped to drive the yen down. Still, they were surprised by the efficiency of their mostly verbal intervention. The reason for yen weakness is therefore not the so-called “currency war” being waged by central banks.
See also: The Fuel of a Currency War
Foreign currency purchases from the Bank of Japan (BoJ)are limited to levels of 5% of Japan’s GDP per year, while the Swiss National Bank (SNB) possesses reserves of 70% of GDP. In 2010 and 2011, during phases of strong risk aversion, verbal and physical interventions with purchases of a similar 5% GDP scale could not stop the yen’s appreciation.
Should the U.S., and subsequently Southern Europe, really go into boom phases of their credit cycles, then the depreciation of the yen will continue. Otherwise, it is just the “Sell in May, Come Back in October” Effect, which sees reduced risk in winter months (also seen on Laidi’s graph above for the year 2012). Higher oil prices and seasonal effects will lead to more risk aversion and a stronger yen during the US driving season. Nonetheless, most “tail risks” seem to be eliminated with ECB President Mario Draghi’s Outright Monetary Transaction (OMT) operation and Fed Chairman Ben Bernanke’s unlimited cheap financing of the new U.S. housing boom.
Read more about the “Sell in May, Come Back in October” phenomenon on snbchf.com.

By George Dorgan, global strategist, SNBCHF.com

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