by Ron Leven.
In the February Market Voice, we made note that contrary to general expectations – and presumably the Bank of Japan’s (BoJ) – the announcement of a negative interest rate policy was greeted with significant strengthening in JPY. Since then, BoJ has continued its commitment to a negative rate, and still JPY has trended stronger with USDJPY reaching its lowest level in over two years. The chart below provides a potential rationale of this seemingly perverse JPY response. The spread between M3 and M1 is an indication of the success of credit creation – or leverage – in the economy. The move to negative interest rates in the first quarter seems to have led to a contraction in credit conditions, causing appreciation in JPY and lower USDJPY rates.
The chart on the following page shows that the first quarter was a period of weakness for the Nikkei. That weakness was tied, at least in part, to a general downturn in global equities. Credit contraction could be a reaction to the equity downturn and only coincidentally reflective of negative interest rates. The failure of the Nikkei to participate in the general equity rebound that emerged later this year, however, brings this rationale into question. FX MARKET VOICE – Answers, advanced. May 2016 – Ron Leven, PhD Even less clear is whether the JPY surge is being driven directly by credit conditions or indirectly via the equity market. Unfortunately, it is difficult to determine the directions of causality with confidence either via regression analysis or analytically. It is apparent that there has been a longstanding link between JPY and equity markets. However, one can make a case for either being the driver. A stronger JPY puts pressure on exporters to lower prices, eating into profitability – bearish Nikkei. On the other hand, declining equity prices compress bank asset holdings and force deleveraging. In part, this involves selling foreign assets and repatriating into JPY – bullish JPY. Our view is that the credit contraction is the primary driver of both the Nikkei and JPY. So far, there are no signs that the credit contraction is reversing.
Exhibit 2: The Nikkei and USDJPY
Another factor pointing to the potential for sustained JPY strength is the evolution of Japan’s current account balance. As shown in the following chart, JPY weakening from 80 in 2012 to JPY125 last year against the USD came in the wake of a sharp deterioration of Japan’s current account balance. In fact, the balance went into deficit in 2014 for the first time since the first Iraq war. Then, Japan had to make a one-time substantial transfer to the United States in support of the military activities. Interestingly, the recent move into deficit was also a byproduct of a unique event. The decision to shut down all nuclear facilities in reaction to the 2011 Fukushima disaster led to a surge in petroleum imports at a time of rising prices. Although Japan continues to rely on imported energy to generate electricity, a current account surplus has re-emerged in response to declining energy prices and healthy growth of exports. The surplus as a percent of GDP is at its strongest level since 2010 – when USDJPY was trading around 90.
Exhibit 3: Japan’s Current Account and USDJPY
A case can be made that current credit conditions and the widening current account already create potential for a move toward USDJPY 100. And, given the perverse impact of negative interest rates, it is not clear what the BoJ can do to stop this trend. Perhaps aggressive unsterilized intervention might help and indeed, Japan’s Finance Minister last week said he was prepared to undertake intervention if JPY made further sharp gains. The US government, however, would probably protest given the gaping current account surplus and the fact that JPY is actually fairly weak in real terms. The chart on the following page shows the trade-weighted JPY deflated both by relative CPI and PPI. Even with this year’s rebound, JPY remains well below the two-decade average in real terms. This suggests that Japanese exporters can tolerate substantial further strength. Unless the BoJ can find a way to get negative rates to create an expansion in higher monetary aggregates, it looks like USDJPY 100 is coming soon.
Exhibit 4: Real-Trade Weighted JPY