Yen is the Weakest Currency in the World over the Past Month

From March 10 through April 11, the Japanese yen was the strongest
currency in the world. 
 It appreciated 4.7% against the
dollar.  Among the majors, sterling
came in second place with a 2.7% gain.  Among emerging market currencies,
the yen edged past the Mexican peso’s 4.4% rise.  
That was then.  This is now. Since April 11, the yen is the world’s weakest currency.  It lost
3.6% against the greenback. The Canadian dollar is a close second with a
3.3% decline.  In the emerging market space, the Chilean peso has been the
worst performer, nursing a 2.7% loss.  
The reversal of the yen
lines up well with the sell-off in US Treasuries and the widening of the US
interest rate premium over Japan.
  The US 10-year yield bottomed near
2.16% on April 18. The dollar bottomed against the yen the previous day just
above JPY108.  The US premium over Japan on 10-year paper bottomed on
April 18 around 2.16%.  
The US 10-year yield has
risen to 2.42% today before pulling back a bit, despite the larger than
expected rise in PPI and the continued recovery in oil prices after staging an
upside reversal at the end of last week. 
  The US premium over Japan rose to
nearly a two-month high yesterday above 2.37%.  
It seems that the markets
move between two main explanatory and descriptive models of foreign exchange.
 
The first relates
to external imbalances.  Currencies move to bring trade balances into
equilibrium.  This is the
traditional approach.  Countries with large surpluses should have
appreciating currencies and countries with large deficits should have
depreciating currencies.    
This is similar to Purchasing Power Parity.  Currencies move to equalize the
price of a basket of traded goods.   It was on such ideas that many
economists claimed that if the US would implement a border adjustment tax, that
the dollar would “automatically” rise
 to offset it.  Even though highly regarded economists, like Martin
Feldstein, argued along such lines, it seemed naive to us.  
The second explanatory and
descriptive model is based on interest
rates. 
 Foreign exchange is the price of
money and so are interest rates.  The two elements of the price of money
seem related even if not in a linear fashion.  It is partly derived from interest rate covered parity, which is the
idea that currencies ought to move to equalize interest rates.  We have
adopted a softer version of it in our divergence narrative.  
World trade in goods and
services was about $25 trillion last year. 
 The turnover in the foreign exchange
market is a little more than $25 trillion a week.  In the major
currencies, capital flows outstrip trade flows by a large multiple.  
 The fragmentation of trade, the extended supply chains, transfer pricing,
competition for market share rather than profit margins may help explain why
trade does not appear as sensitive to currency fluctuations as may have been
the case in the past.  
Moreover, as the net
international investment positions have grown, trade flows do not always drive
the current account balance.
  Japan reported March current account
figures earlier today.  It reported a JPY2.9 trillion surplus, one of the
largest over the past two decades.  However, the goods surplus was about
JPY866 bln.  The key driver was the surplus on investment income.
 That stood at JPY2.2 trillion.  
In Japan’s case, the weaker
yen has not boosted exports very much. 
 Rather a weak yen flatters the
current account not by lifting exports, but by boosting the yen value of the
coupons, dividends, and profits earned abroad.  
The current thinking in the
market is that the Federal Reserve will hike rates in June (95% chance
according to Bloomberg and 83% chance according to the CME). 
 The market is not convinced that a third hike this
year will be delivered.  Bloomberg
calculates the odds at about 45% chance that the Fed funds target at the end of
the year will be 1.25%-1.50%, while the CME puts the probability closer to 40%.
 The market expects the ECB to alter its forward guidance formally in June
and announce tapering intentions in September.  
The BOJ appears to be
pursuing a different course, and one that may not be fully appreciated by the
market. 
  Essentially, the BOJ is no longer
pursuing quantitative easing as it has become understood by market
participants.  The ECB is buying, for example, 60 bln euros of asset a
month. That is the quantitative element.  The BOJ had been targeting JPY80
trillion a year.   However, this is no longer the case, and it has not
been for several months.  

The BOJ has shifted from
targeting a specific expansion of its
balance sheet to targeting interest rates. 
 In addition to its negative 10 bp deposit rate, the BOJ is targeting
10-year yields within a ten basis point range around zero.  To maintain
this range, the BOJ does not need to buy JPY80 trillion of assets.  BOJ
Governor Kuroda acknowledged this before, but this week he provided specifics,
suggesting that its balance sheet is rising at a pace closer to JPY60 trillion.  

The US reports April retail
sales and consumer prices tomorrow. 
 Both are expected to have improved
from soft March readings.  If our analysis is correct, and the key to
dollar-yen is the US 10-year yield than
tomorrow’s data could be important.  However, give the recent price
action, it would seem to require an upside surprise of the data to extend the
rise in US yields and the dollar against the yen.  Initial support for the
dollar is seen in the JPY113.00-JPY113.20
area, and a break could spur a move back to JPY112.00. 

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