WHEN a stagnant economy meets a turbulent political environment, expect volatility. Traders spying an opportunity might want to cast their eyes to the Land of the Rising Sun, Japan.
Over the last two decades, yen bears have been brutally battered as the currency has soared. Since 2007, dollar-yen has fallen by over 60 per cent. However as the economy enters another period of gloom, and the Bank of Japan moves towards even looser monetary policy, the yen bears may yet still have their day.
JAPAN’S TROUBLED ECONOMY
The outlook for the world’s third largest economy looks glum: output contracted by 0.9 per cent in the third quarter (3.5 per cent contraction, annualised), and Japan is likely to fall into its fifth recession in 15 years.
The country has a gargantuan national debt, around 230 per cent of GDP – the largest in the world. “Channelling funds from the private into the sovereign sector has created deflation,” according to a note from Morgan Stanley. Deflation has allowed Japan to sustain this debt. A combination of low interest rates and a deflationary environment has created positive real yields – attractive to investors. This, however, comes at the expense of making the total burden of Japan’s debt mountain even worse.
And demand for yen has inevitably soared due to Japan’s role as a funding currency and safe-haven, as traders fled from the euro and more risky assets. This has added to the pressure facing export dependent corporates, whose goods and services have become more expensive to foreign buyers. Consequently, exports have slumped, and Japan posted a current account deficit in September – the first since modern records began in 1985. Some of this slump can be attributed to tensions with China, a key trading partner, over the sovereignty of the Senkaku Islands (Diaoyu Islands). Chinese consumers subsequently boycotted Japanese goods.
TSUNAMI OF STIMULI
But things could soon change. Caving to pressure from the opposition, Prime Minister Yoshihiko Noda has called a general election for 16 December. If, as polls suggest, Shinzo Abe of the Liberal Democrat Party triumphs, he will be the eighth Japanese Prime Minister in the last 10 years.
Abe, himself a former Prime Minister, is basing his campaign on a pro-inflation platform, favouring an activist monetary policy. He has hinted that he will strong-arm the Bank of Japan into targeting 3 per cent inflation, as well as pushing the base rate towards – or below – zero. The upshot could be tsunamis of potentially unlimited monetary easing, adding to the ¥91trn (£691bn) that the Bank of Japan has injected into the economy via asset purchases.
A weaker yen could help to turn around the Japanese economy, boosting exports as well as domestic demand. However, Abe’s comments have cast a long shadow over the Bank of Japan’s independence, and there are questions whether such policies can work. The Bank’s governor Masaaki Shirakawa said that a policy targeting 3 per cent inflation is “unrealistic” and would have a “negative impact on the economy”. But Kathleen Brooks of Forex.com says “the markets are ignoring that”.
As it is, the Bank has struggled to meet its current target of 1 per cent inflation. Although it remains committed to overcoming deflation, this week it announced that it would keep its base rate and asset purchase programme where it is.
Brooks thinks there is scope for further easing. “They haven’t thrown the kitchen sink at it,” she says. “It seems to be quantitative easing in incremental steps, rather than the wham, bam, thank you ma’am of the Fed,” which is what we could get with Abe.
So with the yen lurking towards seven-month lows against the dollar. Uncertainty over the role of the Bank of Japan could have the impact of increasing yen volatility. Morgan Stanley has said that “additional pressure on the central bank to act more aggressively should catalyse sustained yen weakness,” and their target is for dollar-yen to reach ¥92 next year.
Brooks has a medium-term price target of ¥84, but she warns that a lot still depends on the US. “In the near term, the outlook for dollar-yen is based on how the dollar moves.” If the US Federal Reserve took a hawkish tone, for example, by hinting at a slowing of its easing programme, we could see the yen trading within a range. Therefore, it is important to manage risk, potentially by placing a stop loss at the ¥79.50 level.
The road to Japan is littered with the bloody corpses of yen bears who have fallen on their on swords over the last two decades. The yen’s relentless strengthening has punished them all. However, the prospect of Abe in the premier’s seat could sharpen their resolve. The yen bear may yet have his day.