COMPLETE political gridlock, severe indebtedness and weak economic growth would normally point to a ratings downgrade, deterioration in the currency and a lack of economic reform. But not if you happen to be Japan.
Although all three of the big ratings agencies gave the country another warning shot, none hinted at an imminent downgrade. Despite prime minister Naoto Kan’s inability to retain majority control of the upper house, none of the ratings agencies saw the political stalemate as an imminent threat to Japan’s AA rating.
While Standard & Poor’s (S&P) said earlier this week that it might lower Japan’s rating if the government’s fiscal position is eroded further or if the government fails to come up with concrete consolidation measures, it added that the country “does not urgently require a downgrade”. David Beers, managing director of S&P sovereign and international public finance ratings, said: “I don’t think it clearly makes it more probable. I think we will take stock over the next couple of weeks and months and see.”
But while Japan has been spared a downgrade for now, the currency markets may be less kind to the yen. Although the upward momentum in US dollar-yen has fizzled out thanks to those comments from the ratings agencies, FX traders cannot and should not ignore three fundamentals that would indicate a weaker yen.
First, the lack of a majority government – at best, this will slow down much-needed fiscal reforms and at worst, will degenerate into in-fighting and inaction. Second, the country is weighed down by debt – its outstanding long-term debt is forecast to reach ¥862 trillion by the end of next March, or 181 per cent of GDP. If you add in short-term debt, then Japan’s liabilities will hit 197 per cent of GDP this year and 204 per cent in 2011. And finally, with interest rates at 0.1 per cent, carry trade investors will continue to sell the yen to fund their purchases of higher-yielding assets.
More technical analysis would also suggest that the dollar should strengthen at the expense of the yen. Research by RBS says that dollar-yen is still very cheap and that only twice over the past 40 years has the yen been more expensive than it is right now. Analyst Paul Robson suggests that long-run fair value is ¥110 compared to the current level of ¥88.4. Swap/forwards are consistent with dollar-yen reaching ¥93 within three months and ¥100 in a year’s time.
With both fundamentals and technicals pointing in the same direction, this is a clear-cut trade. But FX traders should be prepared to suffer some volatility and yen strength during bouts of risk aversion.