Return to normality will be bad news for the yen

Kathleen Brooks
TODAY is the last day of Golden Week in Japan, one of the country’s most important public holidays. But the last few months have been anything but golden for the yen. The currency has fallen by more than 10 per cent against the US dollar and nearly 8 per cent against sterling.

There are a two main drivers of yen weakness. Firstly, economic stability. Because the Japanese currency is considered a safe haven, when the economic backdrop improves it tends to fuel yen weakness. So the yen’s woes have grown this week as calm descended on the markets after the Greek fiscal crisis.

Secondly, interest rate differentials tend to drive currency performance, and this favours US dollar strength over the yen. “The yen is a yield play really,” says Michael Hewson, technical strategist at CMC Markets. “The interest rate differential is the main driver of anything against the yen.”

The Bank of Japan slashed interest rates to 0.1 per cent during the financial crisis. As other economies look toward normalising interest rates, Japan, the slowest growing economy in Asia, looks too weak to join them. Recent economic data suggests that unemployment is rising and prices continue to fall, and back in March the Bank of Japan actually extended its programme to stimulate economic growth.

The does not bode well for yen strength. “Dollar fundamentals are slightly better than the yen at the moment,” Hewson adds. The Federal Reserve could even raise the discount rate (the rate at which it lends to financial institutions) at its next meeting. Although the Fed Funds rate is the traditional driver of currency markets, if the Fed raises the discount rate it will be seen as a step towards the normalization of monetary policy, since during normal economic conditions the discount rate is higher than the Fed Funds rate. As Japan’s peers start to hike interest rates the yen is likely to suffer.

But could its Asian neighbour save the yen from a sell-off? Nick Beecroft, senior FX consultant at Saxo Bank, argues that the yen, along with other Asian currencies, should start to appreciate if China decides to revalue its currency – it has been operating a de-facto peg against the dollar since the financial crisis. However, Hewson says that the impact of a revaluation on the yen is difficult to quantify, not least because of the Bank of Japan’s sensitivity to currency rates.

Japan’s economy is largely export driven so a strong yen hurts the economy, which is something foreign exchange traders need to watch out for. “The Bank of Japan tends to get twitchy with anything around the 85 or 90 level against the dollar, which it feels is too high, whereas anything over 120 is considered too low,” says Hewson.

Traders with a long time horizon should also be aware of long-term sources of yen weakness. Apart from Zimbabwe, Japan has the second largest public debt in the world, at more than 190 per cent of gross domestic product. This is affordable for now due to Japan’s high savings rate, but a rapidly aging population means that Japan may struggle to service its public debt burden in the future. The current problems in Southern Europe suggest that the markets will eventually punish unsustainable borrowing rates. “At the moment everyone is fixated on more likely candidates to default, but at some point Japan will have to deal with their debt and a weaker currency is a blessing when trying to deal with a deficit,” says Hewson.

Watch out for any return of risk aversion, but in the long-term, the sun seems to be setting on the yen.