Support For The Yen

Over the last five years, the Bank of Japan has been engaged in a prolonged battle to combat deflation in the Japanese economy to bring conditions back to "normal." The central bank already cut interest rates to zero in 2001 but took the additional step of flooding the market with excess liquidity. The bank adopted a quantitative policy with a target of 30-35 trillion yen for current account deposits held by the commercial banks.

A second element of the policy was to intervene aggressively to prevent yen strength, as a stronger currency would have put further downward pressure on domestic consumer prices. The Japanese central bank, under the direction of the Finance Ministry, intervened heavily to prevent yen gains through the 100 level against the US dollar in the first quarter of 2005, although there has been no need to step in over the last 12 months, given the general dollar gains.

VICTORY AGAINST DEFLATION?

In recent months, the Japanese economy has been displaying solid evidence of an economic recovery. Growth measured by gross domestic production recorded an annualized gain of more than 5.0% for fourth-quarter 2005, supported by solid gains for production, investment, and consumer demand. Bank lending growth has also returned to positive for the first time in more than five years.

As far as inflation is concerned, there was an underlying increase in consumer prices of 0.5% in the year ended January 2006, the third consecutive annual increase, and the increase was the most convincing indicator that deflationary pressure is easing. Positive inflation data was also an important condition set out by the Bank of Japan for returning to a more conventional monetary policy.

After the March 2006 monetary meeting, the Bank of Japan announced that the quantitative monetary policy was being suspended. It will be replaced by interest rate targeting and a reference inflation target range of 0-2%. The bank will reduce excess liquidity in the banking sector gradually over the next few weeks as conditions are normalized.

INTEREST RATES STAY LOW

Despite the policy change, the Bank of Japan will act to keep interest rates at a very low level, with short-term deposit rates remaining close to zero. Short-term interest rates are likely to rise gradually from the third quarter of 2006, with rates close to 0.75% realistic by the end of 2006.

Nominal interest rates will, therefore, remain very low in a global context, which will lessen short-term yen buying interest based on interest rate yields. The withdrawal of excess liquidity will, however, still have a significant impact in lessening yen supply, and this will be very important in stemming underlying yen selling pressure.

Nominal bond yields have already risen, with five-year yields rising to a five-year high at close to 1.2% while 10-year yields are at 1.7%. Historically, yield spreads on bonds have been very important indicators of currency trends, and any narrowing of the yield gap between US and Japanese bonds would support the yen.

IMPACT OF CARRY TRADES

Carry trades have been a very important feature of currency markets over the past six months. Funds and, increasingly, individual investors have borrowed funds in low-yield currencies to invest in high-yield currencies and speculative assets. The target investments have included currencies such as Australian and New Zealand dollars as well as emerging market instruments such as the Brazilian real and Mexican peso. Commodities and energy instruments have also benefited from the trend.

"The currencies most vulnerable to selling pressure have been the yen, Swiss franc, and euro due to their low-yield structure, with the yen particularly vulnerable, given that short-term interest rates remained at zero," notes Matt Blackman, market analyst at www.TradingEducation.com. "A gradual tightening in global liquidity and more restrictive Japanese policy would make it much less likely that the yen would be a selling target."

The Japanese current account surplus fell by 7.6% in the year to January to 719 billion yen as the trade account was undermined by high oil prices and a seasonal drop in exports. However, Japan will continue to run a substantial basic balance of payments surplus during 2006.

The income account will also be a very important focus over the next few months, with the potential for further strengthening. Japan's foreign exchange reserves have increased to more than $800 billion, still primarily invested in US Treasury bonds, while there are substantial holdings of US bonds held by Japanese investors.

An important and rising flow of funds will be moving back to Japan in the form of interest payments. Although these funds may be recycled overseas, the structural capital account surplus will offer important background yen support. These flows will be particularly important in supporting the yen if wider dollar confidence starts to weaken.

REGIONAL SUPPORT

Regional currency policies will also be important for the yen. There is a strong case that the underlying economic fundamentals will put upward pressure on the Chinese currency. US political pressure for stronger Asian currencies is likely to increase ahead of the November congressional elections. Any Chinese yuan appreciation would be liable to trigger wider Asian currency gains, especially if there is growing trade protectionism and US political pressure over the US trade deficit.

There will certainly be the risk of currency depreciation at times, especially if there is a withdrawal of equity funds from Asia, but the underlying trend is likely to be of appreciation.

Japan's position in Asia is complex, given the contrast between the rapid expansion of low-cost manufacturing production in China and the much more mature industrial economy in Japan. It is, therefore, dangerous to assume that Asian gains would automatically translate into yen gains.

The Japanese economy is also still dependent on export growth, and a general downturn in the global economy or a cyclical decline in the US economy would put the Japanese economy under pressure again. Nevertheless, sustained Asian currency appreciation would be likely to support the yen and could trigger opposition to yen gains from within the Japanese Finance Ministry.

Figure 1: HOLDING ITS OWN. Since pushing to the 102 level in late 2004 and early 2005, the yen has remained in a more comfortable area for Japanese policymakers in 2006.

DOLLAR YIELDS CRUCIAL

The Federal Reserve cut interest rates to a low of 1.0% in 2004, eroding the dollar's yield advantage over the yen. The yield gap on 10-year bonds hit a low in the third quarter of 2004, with the dollar/yen rate hitting a low close to 102.0 early in 2005. There has been a gradual recovery in the yield gap and dollar since then as the Fed has steadily increased interest rates.

US bond yields have responded to a lesser extent, but the dollar's advantage has improved slightly. This has helped push the dollar to a stronger position against the yen. The dollar will be more vulnerable once US interest rates appear to have peaked as yields would be likely to decline from that point.

Given the extent of dollar holdings held by Japanese and other Asian investors, there is always the risk of a sudden loss of confidence in the US currency. Overall, structural factors and a savings surplus point to underlying yen appreciation.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.