If you follow this column you know I talk quite a bit about Japan and the yen.
That’s not because I have some special affinity for critiquing Japanese policy. Although I’ll confess that when it comes to central banks, no one eases like BoJ Governor Haruhiko Kuroda, so there’s something profoundly amusing about watching him dive deeper and deeper down the unconventional policy rabbit hole.
But, Japan matters as a sort of barometer for just how far things can be pushed in terms of Herculean Keynesian efforts to boost inflation and growth and also in terms of what the yen’s direction means for risk. The latter point is all about the famous (or “infamous,” depending on how things are going) yen carry trade. It’s a pretty simple concept that every investor (or at least every trader) should understand. Here’s Bloomberg summing it up in just a few words: “... investors borrow money in a low interest-rate environment such as Japan’s to fund investments in higher-yielding assets.” And here’s a good chart that illustrates the point:
As long as the currency you borrowed in depreciates and the assets you bought with your borrowings rise, you’ll make a fortune. If the currency in which you borrowed suddenly rises sharply, well, that’s obviously going to eat into your returns and you’ll need to get out quickly.
The takeaway for US traders: when the yen carry unwinds (i.e. when USDJPY dips), look out below for the S&P 500.
This dynamic makes it especially interesting to watch the market’s reaction to BoJ decisions or, as was the case in April, indecisions. The risk now seems to be that Japan is damned if they do and damned if they don’t. When Kuroda moved to NIRP in January the yen rallied. The move wasn’t as paradoxical as it seemed. Investors simply took negative rates to be a tacit admission that the bank’s other measures (bond and ETF purchases) had reached their limits. NIRP was thus seen as desperate. If nothing’s working, the market reasoned, and there’s no more room to ease, well then the yen would be inclined to appreciate. Then traders just proceeded to frontrun what they assumed would be an eventual BoJ surrender to the inherent limits of Keynesian policy.
In April, by contrast, the BoJ stood pat. That was due to one of two things: 1) the much ballyhooed “Shanghai Accord,” or 2) the fact that January was the beginning of the end in terms of counter cyclical policy room and Kuroda wanted to preserve whatever tiny bit of ammunition he had left. Either way, the yen moved higher.
This week, we got still another example of Japan’s FX Catch-22. As those who follow the country are no doubt aware, Nobel prize winning economist Paul Krugman has twice succeeded in convincing Prime Minister Shinzo Abe to delay a planned sales tax hike. “Japan still has not achieved escape velocity in breaking out of the deflationary cycle,” Krugman said in March after meeting with policy makers in Japan.
Well, fast forward to the G7 meeting hosted by Japan this week, and Abe pulled a ridiculously transparent stunt to justify delaying the tax hike. On Thursday, he trotted out some “documents” which he claimed proved the world was careening towards another Lehman moment. That was amusing because, as Bloomberg wrote, “Abe has frequently said that he would proceed with a planned increase in the sales tax in April 2017 unless there is an event on the scale of the Lehman shock.”
So basically, Abe first said he would delay the tax hike if a Lehman event was coming, then promptly turned around and confirmed for himself that … wait for it ...a Lehman event was coming. That’s a convenient way to get things done. As Barclay’s put it: “Abe is indicating a postponement of a sales-tax hike by using the word Lehman.”
Ok, so what’s the point? Well the point is that as Krugman said, the justification for not implementing the tax hike is that higher taxes will hold back the economy and thus contribute to more deflation and generally work at cross purposes with expansionary monetary policy.
But ask yourself this: isn’t there the possibility of yet another lose-lose dynamic taking hold here for Abe? What happens, for instance, if the details surrounding the delay in the consumption tax end up boosting market confidence in the future of Japan’s economy and thus drive yen strength? That would obviously be a disastrous outcome as yen appreciation would negate the economic strength that triggered it in the first place!
If you want to understand just how convoluted this merry-go-round has become for Japan, consider the following from BofAML:
“Let’s realistically suppose the government will postpone the consumption tax rate hike for two years, implicitly expand room for a future tax increase, and roll out fiscal stimulus of about ¥5tn. Stock markets will probably react favorably at margin, but room for an equity-led USD/JPY rally based only on these measures may be limited. However, this is more likely to lead to market speculation for BoJ’s additional easing as part of the government’s full-fledged policy response if the original “three arrows” of Abenomics are emphasized again ahead of the national election in July.”
In other words: who knows?
What we do know is that there those who clearly think there’s a risk of the yen rallying if for no other reason than that there’s just not much more the BoJ can do. Indeed, Finance Minister Taro Aso recently threatened to intervene directly to curtail “excessive” yen strength.
Some equity investors I’ve spoken with seem to have missed the point on that. “Look at the BoJ’s balance sheet!” they’d say. “The yen can only go lower!” Well, the country’s Finance Minister doesn’t seem to agree.
And neither does BofAML (note the reference to the possibility that the equity dynamic may overshadow a rate hike when it comes to driving JPY strength):
“From a medium-term viewpoint, however, this short-term rally in USD/JPY is probably a bear-market rally and can be taken as an opportunity to sell if it materializes. The period after the July election should see a concentration of bullish yen risk factors: (1) domestic flow dynamics remaining yen-bullish; (2) our quants strategy team warns of US equity sell off over the summer and USD/JPY, often more closely correlated with US stocks than with US short-term interest rates, is at an asymmetrical risk from the Fed’s policy and the US economy (Chart 7); (3) protectionism and dollar-negative rhetoric could pick up in the US presidential race around the national convention in the summer; (4) Jul-Oct has negative USD/JPY seasonality (Chart 8); and (5) a change in the priority of economic policies if constitutional reformists achieve a landslide victory in the July election.”
How about Barclays?
“We maintain a neutral stance with respect to Japanese equities, while forecasting a continuing trend of JPY appreciation with respect to the USD (our forecasts: 100 at end-June; 98 at end-December) and the EUR (106; 97) and believe the expected returns on JPY longs will be large especially with respect to the EUR.”
Lastly, here’s some great commentary from Deutsche who took a look at what it means for the JPY that the ECB now has more scope to ease than the BoJ (although that, in and of itself, is a debatable proposition):
“The risks are skewed towards further JPY strength. There has been a structural shift in Japanese hedging behavior and BoP data suggests that domestics are still under-hedged for yen strength. Ability and willingness to shift inflation expectations higher is also declining. Sell EUR/JPY on diverging drivers, target 110.
“We like selling EUR/JPY on rallies as both balance of payments and central bank trends are diverging. European flows remain very weak with the recent pickup in FDI suggesting these may be shifting towards unhedged outflows. The ECB has more scope to push risk premia down and further expand its balance sheet while Japan is running out of options and the odds of aggressive and successful stimulus are low.”
So, mind the USDJPY traders. Although there are still plenty of noted commentators who believe Japan’s headlong plunge into the Keynesian abyss could end up destroying the yen (Yukio Noguchi, a former Ministry of Finance official told Bloomberg this month that if “the nation’s economic strength weakens, it is possible the yen could drop to 300, or 500, or 1,000 to the dollar”), there’s a growing chorus that thinks politics combined with the BoJ’s increasingly limited options could drive notable bouts of strength.
And that, as we’ve seen, is bad news for risk including the S&P.