Forex Investment and Currency Trading

The financial turmoil and the associated unwind of the carry trade has resulted in a stellar outperformance of the JPY, much of it coming in the past 6 months. On a trade-weighed basis (TWI), the Yen has appreciated by 40% since last summer, outstripping the performance of its regional piers. The CNY has also been relatively strong, but appreciated by only 15% on a TWI basis, and the rest of the G3, the Euro and USD have only appreciated by 5-6% over the same period. Finally, the other big funding currency, the CHF has only appreciated by 11%.

The performance of the Yen has shifted the currency from notably undervalued, to significantly expensive, both against the USD and on a TWI basis. The Yen’s current macro backdrop is not supportive of this degree of richness, indeed the deterioration of the Japanese economy would warrant a weaker Yen to ease financial conditions. Japanese investors in aggregate remain very strong buyers of foreign portfolio assets, mainly driven by strong overseas investments by public pension funds, while investment trust related flows have become much more neutral and Japanese households have started to repatriate foreign bond investments, which have been a source of strong outflows in the past. Nevertheless, overall Japanese buying of foreign equity in October and November last year reached new record outflows.

The Japanese economy has deteriorated significantly
Like elsewhere, the Japanese economy has been battered by the headwinds from the severe economic downturn, despite – on the surface – being relatively less affected by the credit crunch. The Japanese export performance has been slowly deteriorating for several years, however in the latter quarter of 2008, Japanese exports plunged by 26.5% yoy. This is a worse decline than recorded by other Asian nations when considering the region’s export performance in local currency terms rather than in US$.

In light of the deterioration in economic activity, Japan needs easier financial conditions. The Yen appreciation has contributed roughly 75% of the tightening in financial conditions since last August, with the performance of the Nikkei accounting for the rest. Indeed Japanese financial conditions are notably tighter than elsewhere.

Given that rates in Japan are all but at zero, it leaves weakening the exchange rate as the main avenue for easing financial conditions. Comments from the Japanese authorities indicate that it is the speed of appreciation which is of most concern rather than the level. It is notable that the most explicit statements on Yen strength have come swiftly after a sizeable daily appreciation.

However the level might start to matter more. Japanese exporters are suffering from the strength of the Yen. Disappointing Q4 earnings results did mention the Yen as a negative factor. The continued strength of the Yen against lacklustre external demand is likely to remain a challenge for Japanese exporters.

Clearly, commentary from the BoJ/MoF needs to be closely monitored, any rapid appreciation of the Yen is likely to illicit a warning shot from the Japanese authorities.

Ad for the unwinding of the so-called “carry trade”, trying to determine the size of the carry trade has obsessed many market participants for a long time, and it remains very unclear, other than it is now much lower than it would have been a few months ago. Given that it was possibly built up over many years, it is conceivable that it takes years to unwind and indeed, this may still be the main source of Yen strength currently. Indeed the continued high correlation between key Yen crosses and other risky assets suggests that some carry related hedging asymmetries continue to persist. It is therefore difficult to judge just how far the unwinding of carry has come and whether it is already in the process of disappearing as the dominant factor.

Near-term Yen direction from here
The Yen has been hostage to opposing forces for the past couple of months, evidenced by Usd/Yen’s tenacity around 90. The Yen is likely to remain stuck until one force starts to clearly dominate. We should be closely watching the weekly portfolio flow data from the MoF for clear signs of repatriation, a sign that the Yen could gain ground below 90. However if the green shoots of better sentiment become more firmly established, focus on the relatively more challenged Japanese economy compared to elsewhere could well push the Yen weaker. In that environment, some of the Yen crosses would look stretched.