Forex Investment and Currency Trading

Having judged that the JPY’s surge and its interaction with domestic equity market sell-offs have intensified downside risks to the Japanese economy and the financial system, the Japanese authorities have begun to take policy steps to stem adverse market moves. As for the impact of the stronger JPY on the Japanese economy, because crude oil and raw materials prices have turned down, negative effects on exports now outweigh benefits of lower import costs. In fact, the Japanese economy’s reliance on external demand has been on the rise. The ratio of exports to GDP rose to 16.2% during the year to 2Q08 from 15.6% in 2007 and 14.7% in 2006. With the bleak overseas demand growth outlook, continued JPY gains well above these levels would exacerbate declining business sentiment, adding to downside risks to the economy. The Japanese government has started with measures to support equities, which may also help limit (but certainly not eliminate) intensification of risk aversion for currency investors.

Textbook theories suggest that the most effective policy steps to stem JPY gains might be a coordinated intervention backed by Japan’s monetary policy easing. However, analysis of Japan’s past intervention confirms limited impact on prices, as only 46% of the 298 JPY-selling interventions during 1991-2004 (and 52% during 2003-2004) ended up with higher USD/JPY levels in the following five business days. USD strength versus the EUR has kept market expectations for joint intervention very low, despite the G7’s statement on October 27 addressing shared concerns about excessive volatility in the exchange rate of the yen following the USD/JPY drop to the lowest level since 1995 at 90.93 and the EUR/JPY decline to the lowest level since 2002 at 113.64.

The MoF/BoJ could still be forced to intervene, as there remains tremendous uncertainty about chances of further unwanted risk reductions spurring JPY gains, and as interactions between JPY gains and falling equities on downward revisions to profit expectations have increased bank balance sheet constraints and financial system risks. MoF/BoJ intervention is only likely if there were to be a continued sharp USD/JPY drop below 90 and sharply falling domestic equities that posed serious
risks to the financial system. Further, the BoJ is most likely to leave the overnight interest rate unchanged at 0.50% and any rate cut should be 25bp, smaller than prospective cuts by most other central banks.

Markets have already priced in the likelihood of much more aggressive policy rate cuts for other major countries than for Japan. Thus, further JPY gains would arise mainly from risk aversion, which will remain subject to how long and how bad the global financial crisis will be. Still, narrower foreign-domestic interest rate differentials on the top of declining risk-taking ability will probably lower Japanese investors’ preferred entry levels for unhedged foreign currency asset investment, constraining the downside for the JPY. Both the current Nikkei Index level (7,622) and USD/JPY level (around 95) are below the break-even levels for valuation gains/losses for seven out of the nine major Japanese insurers, based on their March 2008 disclosures. Japanese retail speculators have also been trapped by sharply falling equities and foreign currencies. The FX margin net long (EUR+GBP+CAD+AUD+NZD)/JPY position on the Tokyo Financial Exchange dropped to $0.42bn on October 27, the lowest since November 2006, while the net USD/JPY position has remained low since mid-July. Assuming a modest easing of pressure from the global financial crisis, market expects a USD/JPY rebound to 101 at year-end.