In the first quarter of 2008, the Japanese yen rocketed higher against the greenback to hit nearly 13-year highs. In doing so, the USD/JPY pair dropped below the psychologically critical 100 barrier to a low of 95.71 without even a hint of FX intervention by the Bank of Japan. Yen strength, however, was driven strictly by risk aversion dynamics rather than by any improvement in Japan’s economic fundamentals. In fact, if anything, Japan’s economy deteriorated materially as the quarter progressed, adding to evidence suggesting that a global slowdown is in the works. However, a jump in energy and food costs have finally started to spur price pressures in the economy, putting any notion of a Bank of Japan rate cut on hold. Nevertheless, with the source of the inflation strains due purely to volatile commodity price gains, rather than a broad increase in domestic demand, any significant pullback in oil and food costs may give the Bank of Japan the green light to reduce rates.
This has carried little weight with traders though, as they ignored the economic news from the land of the rising sun and focused strictly on risk aversion / risk assumption dynamics. Thus, as the wrath of the credit crunch spread through the global financial markets, with most major banks writing off billions of dollars in losses, USD/JPY declined on risk aversion flow. Looking forward to the second quarter of 2008, the pair is likely to follow a similar path, as the relentless lowering of US interest rates by the Federal Reserve has removed most of the luster from the USD/JPY carry trade. Furthermore, the credit crunch is far from over and its effects continue to ripple throughout the system, which creates significant downside potential for the equity markets and other ‘risky’ assets.
Is the Carry Trade Over?
The status of risk aversion is the primary determinant of price action in the Japanese yen pairs, and signs have been emerging over the past few months that conditions are far from optimal for the carry trade to thrive. First, overnight index swap rates - a measure of the spread between central bank overnight lending rates and 3-month Libor rates - have been increasing significantly in the US and in Europe, suggesting that banks are still worried about counterparty risk and do not want to lend to each other. In fact, swap rates have recently rebounded to the levels seen just before Bear Stearns nearly had to file for bankruptcy because of liquidity concerns. Furthermore, volatility remains extremely high, and at times like these, traders tend to pull their money out of risky assets such as equities and currency pairs like USD/JPY and EUR/JPY. As you can see in the chart below, volatility - as measured by the VIX Index - was extremely low for most of 2005 - mid-2007. During this same period, the USD/JPY appreciated more than 20 percent! However, once the VIX started to spike higher, the pair gave up nearly all of those gains, and more. With these conditions unlikely to subside dramatically anytime soon, risks remain very much to the downside for carry trades and thus, the Japanese yen pairs.
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Japanese Consumers Remain Deadweight
Given the strength of the Japanese labor markets over the course of 2007, the consumer had been widely expected to make a comeback and help to fuel expansion. However, nothing better demonstrates the exact opposite than the woeful readings of the Eco Watchers survey. This “man-in-the-street” poll of barbers, taxi drivers and waiters is our favorite gauge of Japanese consumer sentiment because it captures the up to the minute spending habits of millions of Japanese consumers. In January the survey dropped to 31.8 - its lowest reading in six years as it sank ever deeper below the 50 contraction/expansion line. The survey has since recovered to 36.9, but this is still near the lowest levels since the months followed September 11, 2001. The news suggests that Japanese consumer confidence will remain low for the foreseeable future, and does not bode well for already soft spending reports. It became clear in 2007 that businesses were not increasing wages despite the tightness of the labor markets, and with the jobless rate starting to tick up to 3.9 percent, there will be little impetus for payrolls to increase. The most recent retail trade reading shows a 1.0 percent drop in the month of February - the worst decline since June 2007 - while overall household spending stagnated during the same month from a year earlier.
As the Global Economy Slows, So Will Japan
The consumer side is not the only soft spot in the Japanese economy. The country’s once mighty industrial sector has started to falter as well, thanks to slowing global growth and the rapid appreciation of the Japanese yen. Indeed, the Bank of Japan’s Tankan survey showed pessimistic sentiment amongst manufacturers in the first quarter, as the index fell to a five-year low of 11 from 19, while the outlook tumbled to 7 from 15. Even worse, the Tankan survey showed that planned capital expenditures by manufacturers and non-manufacturers alike fell 1.6 percent - the sharpest drop since the fourth quarter of 2002 - down from 10.5 percent in the fourth quarter of 2007. While Japan continues to accumulate massive trade surpluses, the country’s export-oriented structure is clearly showing its weaknesses as the economy remains vulnerable to a US slowdown while unable to generate sufficient consumer demand at home to resuscitate growth.
BOJ On Hold Despite Economic Conditions and New Governor
The Bank of Japan started out the second quarter with a new Governor, Masaaki Shirakawa, who left rates steady at 0.50 percent. Indeed, the former Bank of Japan Governor Toshihiko Fukui ended his five-year tenure on March 19, 2008, and was best known for putting an end to zero interest rate policy (ZIRP) in July 2006 with a 25bp rate increase. The move was monumental at the time as a symbol of the end of the economy’s long battle with deflation. The Bank of Japan enacted another 25bp rate hike in February 2007, and as fears of asset inflation stirred throughout the economy, Fukui kept hopes for another rate increase alive for much of 2007.
After much political jockeying between the Democratic Party of Japan and the Liberal Democratic Party, former Bank of Japan Executive Director Masaaki Shirakawa - who wasn’t even being considered for the spot a few weeks ago and was initially only approved to serve as a Deputy Governor - was finally nominated by Prime Minister Yasuo Fukuda and approved by the Diet on April 9. Shirakawa, who earned his master’s degree in economics from the University of Chicago when Milton Friedman was a dominant presence at the school, is likely to remain just as focused on price stability as Fukui. However, as the liquidity crunch takes a severe toll on the global financial markets and Japanese inflation appears to be purely the result of volatile food and energy places, the Bank of Japan is now considered to hold a far more dovish lean and leaves the new central bank governor in an unsavory position.
EURJPY Risks to the Downside Amidst Risk Aversion, ECB Prospects
Although the first quarter was a very productive time for EUR/USD longs, EUR/JPY languished in a 162.00-152.00 range reflecting the waning influence of the carry trade in the currency market. With credit concerns still roiling the equity markets and the rescue of Bear Stearns creating ripple effects throughout the financial system, it was not a great time for carry traders as risk aversion ran high. Risk appetite returned by the end of the quarter as fears of a financial collapse abated, but the net result was that both the euro and Japanese yen strengthened, leaving the pair at standstill. Looking ahead, the risk in the pair skews to the downside, as growing evidence of global economic slowdown is likely to continue to pressure equity markets across the globe and the process of deleveraging is likely to keep the yen well bid. Furthermore, EUR/JPY has been the preeminent beneficiary of carry trade flows because of its liquidity and the European Central Bank’s staunch refusal to lower rates. However, if economic growth in the Euro-zone begins to decelerate rapidly or inflation eases, market participants will begin to price in the possibility of rate cuts sometime this year. If the ECB does indeed change its policy, the impact on the pair is likely to be severe as all the dynamics that have helped support it, namely, the widening interest rate differential, will now begin to undermine it and could put tremendous downward pressure on the price of the cross.
Key Points
The first quarter of 2008 has witnessed monumental volatility throughout the financial markets and a surge in risk aversion, and these factors will likely continue to play a role in Japanese yen price action in the second quarter as well. Furthermore, despite the lackluster Japanese fundamentals, the directional bias in the USD/JPY pair appears to be skewed to the downside as the relentless compression in interest rate differentials engineered by the Federal Reserve has made the carry trade less and less attractive as time goes on. If the global slowdown scenario does indeed come to fruition and major stock markets proceed to plummet, USD/JPY could easily pierce the psychologically critical 100 barrier once again to target fresh multi-year lows as flight-to-safety ensues. With the Bank of Japan left with little wiggle room when it comes to monetary policy in coming months, the direction in the pair in 2008 will be driven almost exclusively by US economic news and risk aversion trends.
USD/JPY Technical Outlook - By Jamie Saettele
There is no change to the longer term call for a drop to below 80. Remember, bigger picture the USDJPY completed a 12 year correction in the form of a triangle at 124.13. We wrote last month that “the USDJPY may be entering a 3rd of a 3rd wave down, which means that the decline should accelerate. The minimum target is not until 100.00, so reward/risk favors bears.” The drop to 95.72 is was wave iii of 3 as we had thought. The rally to 102.95 may have completed wave iv of 3, although a triangle remains a possibility. Even if wave iv does unfold as a triangle, the wave iv high is already in place at 102.95. Expectations are for the USDJPY to drop below 95.72 and complete wave 3 within the 5 wave drop that is underway from 124.13. A wave 4 correction will then unfold.
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