About the authors: Marc Chandler is Chief Market Strategist for Bannockburn Global Forex, a division of First Financial Bank. Omkar Godbole is a freelance currency writer.
The Japanese yen fell like a rock. The market became convinced that, arguably after a late start, the Federal Reserve has entered the most aggressive tightening cycle in a generation. During this time, the
Bank of Japan
signaled its willingness to cap its 10-year bond yield at 0.25% indefinitely.
The yen depreciated 6% against the US dollar in April, pushing the dollar above 131 JPY for the first time in two decades. The demand for dollars was so intense that at one point it rose for 13 consecutive trading days. According to the Organization for Economic Co-operation and Development’s purchasing power parity measure, the yen is more undervalued against the dollar today than at any time in more than 30 years.
While the yen is historically undervalued, the forces pushing it lower have not been exhausted. The divergence between US and Japanese monetary policies is glaring. The United States is tightening monetary policy aggressively, while Japan is applying an open-tap monetary policy.
It has long been believed that the world’s third-largest economy is export-driven. Therefore, Japanese policymakers should prefer a weak yen. But, at best, this belief is a distorted echo of the past. At worst, it may be a deep misunderstanding.
Last year, Japan recorded an average monthly trade deficit of 139 billion yen (about $1.2 billion) compared to an average monthly surplus of 32 billion yen in 2020. Japan’s exports account for about 17.5 % of its gross domestic product, higher than that of the United States at 12%. But other advanced economies export a much larger share. Canada and the UK export about a quarter of their GDP, while Germany exports 47%. And although Japan still has a current account surplus, it is not trade driven.
Some would say that the depreciation of the yen would make Japanese products cheaper on the international market, thus increasing its exports. But Japanese companies reacted to the chronic pressure of appreciation of the yen by relocating. This new dynamic helps explain a recent Reuters survey that found Japanese businesses worried that the weaker yen could weaken consumption and capital investment. The rolling 24-month correlation between yen weakness and Nikkei performance has fallen to its lowest level since 2005.
In addition to the gaping monetary policy divergence, Japan is experiencing a terms-of-trade shock. Rising energy, commodity and food prices are boosting imports faster than a weak yen is boosting exports. Moreover, the J-curve theory suggests that trade deficits initially worsen with currency depreciation, since prices adjust faster than quantities. The expected delayed positive impact on exports could be elusive, as ongoing global policy tightening will likely lead to demand destruction. The depreciation of the yen, however, will increase the value of current account components such as investment-related flows (dividends, coupons), profits, license fees and royalties.
What next for the yen? The Russian invasion of Ukraine was understood in economic terms as a disruption of supplies, foodstuffs, energy and certain metals. We have seen an appreciation in commodity prices and currencies that were thought to be linked to commodities, such as the Australian and Canadian dollars, the South African rand and many Latin American currencies. But China and its Covid strategy are producing another wave of disruption as large parts of its economy are locked down again. The net result was a demand shock.
The divergence in monetary policies seems more persistent. It underlies various inflation experiments. The consumer price index in the United States rose 8.5% in its last reading, while that of Japan is still below 2%. US inflation may be close to peaking, but it will remain high. April data shows Tokyo’s core CPI rose 1.9% from a year ago. The government has imposed a deflationary reduction in mobile phone charges in 2021, but this change will disappear from the 12-month comparison. Nevertheless, Bank of Japan Governor Haruhiko Kuroda argues that the rise in inflation will not be sustainable and that the economy still needs extraordinary monetary accommodation.
Some believe that if the BOJ gave up its control of the yield curve, the yen would strengthen. But where would the return go? The 30-year Japanese government bond yields less than 1.0%. The exchange rate is also more correlated to the 10-year US Treasury note than to the 10-year Japanese government bond.
While the BOJ under Kuroda appears to be enjoying the benefits of a weak yen, the Treasury is more concerned. The rhetoric gradually got stronger. First, the department expressed concern about the pace of depreciation. Then he threatened to take appropriate action if necessary. The ministry climbs a climbing ladder.
However, the bar for actual hardware intervention seems high. The yen’s weakness reflects fundamentals, the head of the International Monetary Fund’s Asia-Pacific department said recently. The intervention also seems to work best when it signals an adjustment in underlying policies, but this would not currently be the case. Nor is it clear that the US would appreciate dollar selling when the Federal Reserve scales back monetary easing.
Of course, Japan doesn’t need US permission, but its blessing wouldn’t be so bad.
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