The Edmond Sun


March 23, 2012

Why is the Japanese yen rising?

EDMOND — What’s up with Japan — the currency, that is?

Since the global financial crisis of 2008 the Japanese yen has been one of the strongest major currencies in the world.  This is surprising because it should be a weak currency. Now that the European debt situation is off the headlines (for now), we should look at another area that has been moving under the radar.

Let’s look at the dollar/yen exchange rate. In late 2008, a dollar would buy you 110 yen. Today, a dollar will only buy you 82. And remember, the dollar has been relatively strong over the past four years. The yen’s performance against the euro or British pound would be even more dramatic.

This is surprising because Japan is the most heavily indebted major country in the world. Isn’t everyone trying to avoid sovereign risk these days? Japan’s sovereign debt is currently 220 percent of GDP and getting worse by the day. By comparison, the U.S. is approximately 100 percent of GDP. Japan’s annual budget deficit has routinely been in excess of 10 percent of GDP. On top of that, investors are not really getting compensated for holding yen. Japanese short-term rates have been at or near zero for almost 20 years, and even their 10-year bond yields a measly 1 percent.

So what’s going on here? Have currency traders gone blind? Not likely. For many years, the yen was the primary funding currency for the carry trade that so many hedge funds participated in. In a typical carry trade, a trader will borrow money in a low-yielding currency like the yen and invest the money in a higher-yielding currency like the Canadian or Australian dollar or, until recently, the euro or pound.

The trader would make money in two ways. First, they earn an interest rate spread, the difference between their borrowing rate and their lending rate. This is how banks operate in the lending markets as well, borrowing cheaply and lending at a higher rate. But there is also a secondary benefit. These activities of traders tend to create trending markets. Low-yielding currencies trend downward and high-yielding currencies trend upward. So, in addition to the interest rate spread, traders also enjoy gains from an improving currency exchange rate.

At least they used to. The game has now changed. When the capital markets ground to a halt during the 2008 meltdown, there was a rush by traders and investors to deleverage, i.e. pay down debt. When it seemed like the financial world was ending, it didn’t make sense to owe a lot of money.

Traders responded by closing out their carry trades, which caused the old game to operate in reverse. They had to scramble to buy yen rather than sell them so they could pay off the loans in yen. It wasn’t exactly the same as a short squeeze, but the results were pretty much the same. With massive buying of the Japanese yen going on, the yen shot up in 2008 and early 2009, causing the yen to gain on all major world currencies.

Of course, this begs the question, why didn’t the yen decline in the years that followed? Here, the answer is less clear, but a few reasons are likely. First, the carry trade lost its appeal after a lot of traders got burned. Many found out that going the wrong way when the carry trade reverses can get really ugly. It is a lot harder to do now and many came to view it as picking up nickels in front of a steamroller. Too much risk for too little return. And secondly, the attention of active currency traders shifted to Europe and its sovereign debt crisis, giving the yen some breathing room.

But more fundamentally, the yen now has a lot of competition as a funding currency from other low-yielding currencies, not the least of which would be the dollar. In a world in which nearly every major currency yields close to zero, the yen is no longer unique as a funding currency.

Even with all of this as explanation, the yen’s persistent rise is a mystery, particularly when you consider that Japan’s exports are down and the economy is limping along. As some of my favorite technical analysts would say, “When you see a trend like this that is hard to explain, you might want to question its sustainability.”

Financial writer John Mauldin referred to the Japanese economy as “a bug in search of a windshield” in his recent book “Endgame,” and that is a pretty good metaphor.

Japan’s huge debts and deficits have only been possible due to the country’s historically high savings rate — a savings rate that has been trending downward in recent years and may well turn negative soon. The Japanese have been great savers and have tended to be patriots who bought their own government debt. Now that their population is getting much older, they are now spending down their savings. Who will buy Japanese government debt when a large portion of their population is spending their savings in retirement, not increasing it?

When Japan has to turn to the international bond markets to fund its deficits, it’s not going to enjoy a 1 percent yield on its 10-year obligations. No one, outside of the Japanese themselves, would lend Japan money at 1 percent.

In the rolling global debt crisis, Japan will be the next major domino to fall. When it finally has to access the international bond markets, its yields will rise to punishingly high levels, just like Greece, Italy, Spain and Portugal recently. At that point Japan will have one of two choices, both of which will almost certainly result in a hyperinflationary meltdown — default or use the government printing presses to meet current obligations.

The bottom line? If you are a long-term investor, I would suggest you stay out of all Japanese assets. The risks simply aren’t worth it given the attractive options you can find in the United States and Europe. If you are a short-term trader, get ready. At some point in the next 1-3 years, Japan could prove to be the best shorting opportunity of your trading career. Thanks for reading.

NICK MASSEY is a financial adviser and owner of Householder Group Financial Advisors in Edmond. Nick can be reached at Securities offered through Securities Service Network Inc., member FINRA/SIPC.

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