Forex Investment and Currency Trading

The past two weeks has witnessed a sea change in the way the Yen has traded. ‘Risk off’ days are now associated with Yen weakness rather than Yen strength, the opposite of the pattern observed through this financial crisis. This is further highlighted by the decoupling of the Yen crosses and Yen TWI from moves in equity markets. What has changed?

The market now realises that the Japanese economy has difficulties

One specific reason, why more Yen selling may occur is the realisation that the Japanese economy is facing extreme difficulties. The economy shrank by 12.7%qoq annualised in Q4. This revelation appears to have shifted the market’s focus towards the Japanese macro data and away from solely looking at the Yen in terms of how much of the carry trade there is left to unwind. Data for Q1 so far is grim. Industrial production fell by 31%yoy in January, retail sales and consumption remain weak. Export volumes fell by 41% against the backdrop of the continuing slump in global demand and Yen strength.

Yen-supportive exporter hedging flows are likely to be limited until there are signs of a recovery in global activity. The weekly Ministry of Finance cross border flow data indicates that Japanese appetite for foreign assets continues unabated. Japanese buying of foreign bonds was particularly strong in recent weeks. At the same time, foreign investors remain net sellers of Japanese assets, particularly equities. The December Balance of Payments data indicated that the Japanese BBoP (current account plus net FDI plus net portfolio flows) had slumped to a deficit of 4.8% of GDP on a 12-month ma basis, the worst BBoP deficit on a trend basis since the data began.

Against this slew of bad macro data, it is difficult to view the Yen as a safe haven. The Japanese banking sector seems to have weathered the financial turmoil better than many others around the world. However, the macro economy has taken a bigger hit. Japan’s Q4 GDP print is the worst of the major economies so far. If policy activism matters, the Japanese have done less to solve their country’s problems than elsewhere. On some metrics the Japanese authorities have less room for manoeuvre. Policy rates are as low as they can be and Japan’s large budget deficit suggests a lack of room for fiscal stimulus. Bottom line: market expects Japan to be the worst performing major market of 2009, and more downside risks to this view.

Despite the weakness of the Yen in recent trading, the currency remains overvalued. This sits uncomfortably with the challenges facing the Japanese economy and the deterioration in the external balance. Indeed both argue for a continued erosion of the Yen’s ‘richness’ relative to trade-weighted ‘fair value’. One way of looking at this is from a financial conditions perspective. Japanese financial conditions remain very tight particularly given the deterioration in activity. Tight conditions are down to the appreciation of the exchange rate and continued decline in the equity market. With rates bumping against the zero bound, Japan needs a weaker exchange rate (or an equity market recovery, which does not look very likely near term) in order to ease financial conditions. Given the move in the Yen, intervention by the Japanese authorities to weaken the currency is much less likely than it was in early January. Outside of intervention it is entirely possible that the macro backdrop and further deterioration of the external balance causes the Yen to weaken further.