The Yen May Be Shifting Gears

The yen is up again, and superficially, it looks like a repeat of a predictable sequence: risk perceptions rise, investors start to shed risk, carry trades unwind, yen rallies, everyone calms down, the yen falls and the carry trade resumes. Since the Japanese love a cheap yen and domestic investors are well conditioned to buy foreign assets when the yen is strong, it’s almost a patriotic duty to sell the currency (although there nevertheless appears to be a secular trend upwards).

I am generally leery of “this time is different” observations, but since the cheap yen is not sustainable (there will eventually be a limit as to how many of our Treasury bonds they can stand to buy), signs of more significant changes in the dollar/yen trade are worth noting.

Today’s Financial Times says that the scramble to buy yen isn’t simply related to exiting of risky trades, but also includes asset types that were previously unimplicated in the rise of the yen.

This shift could also be a harbinger of more serious developments, since cheap borrowings in yen have been a major source of global liquidity. Although it is not clear how it is related to the yen rally (a higher yen is always a downer for most Japanese companies, which are heavily export dependent), Cassandra notes that the melt-down in the Nikkei has the quality of being fueled by the hemorrhaging of a major portfolio.

From the Financial Times:

The current turmoil in financial markets has revealed the extent to which the low-yielding yen has funded soaring global asset prices in recent years.

Last year, the yen tumbled to multi-year lows against a raft of currencies as carry trade investors sold the currency to finance the purchase of riskier, higher-yielding assets elsewhere.

But now, as asset prices falter, the yen is threatening to climb sharply to levels that might alarm the Japanese authorities.

The Japanese currency has soared in recent days as fears of US recession have prompted a fresh exodus from carry trades.

On Wednesday it surged to a 2½-year high of Y105.93 against the dollar, taking its gains since the start of the year to 5.1 per cent.

So far in 2008, it has risen 3.2 per cent against the euro, 5.3 per cent against the pound, 3.9 per cent against the Australian dollar and 6 per cent against the New Zealand dollar.

But analysts say the current unwinding of carry trades differs from those that occurred during bouts of risk aversion last year.

This is because the yen’s rally has come amid falls not just in high-yielding currencies and equities in developed markets, but also in metals and emerging market stocks.

Simon Derrick at Bank of New York Mellon said it was becoming clear just how broadly the yen had been used to fund investment across the financial markets, not just the purchase of high-yielding currencies. “You can see from the sharp drops across a whole range of high-yielding assets the extent to which the yen has been used as a funding vehicle,” he said. “This is going to run and run. The yen clearly has room to strengthen considerably.”

This should trigger alarm bells in Japan, where Toshihiko Fukui, governor of the Bank of Japan, has emphasised the downside risks to growth due to deteriorating conditions in the US.

Sebastian Galy, strategist at Dresdner Kleinwort, said Japanese authorities would not allow a strengthening currency to push the country’s economy into recession.

“Intervention is therefore almost certain if we see another bout of strong yen appreciation,” he said.

The last time the Japanese authorities intervened to stem yen strength in March 2005, they drew a line under dollar/yen at Y101.

But Mr Galy said Japanese intervention was more likely against a basket of currencies. The flow of the country’s trade has changed and the US elections are bound to provoke a backlash against dollar intervention. “Hence, the intervention level is probably lower than Y101 against the dollar.”

The activity of yield-hungry Japanese retail investors may also alarm authorities, providing an extra incentive to try to cap the yen.

Tokyo Financial Exchange data show retail margin traders have taken advantage of the stròng yen to raise their bets against the currency to levels not seen since last August, when a currency rally caused them considerable pain.

Note that yours truly is long yen, not that opinions matter in markets this deep and liquid.