What The Strong Yen Means
Currency Strength and Quasi-Depression, Japan-style
By blackhedd Posted in Dollar | Economy | Interest rates | Japan — Comments (11) / Email this page » / Leave a comment »
As the US dollar weakens, other currencies necessarily increase. The euro is now trading above $1.48 to the dollar, a record high. And the Japanese yen is stronger than 109 to the dollar, a two-year high.
All currency movements proximately reflect differentials in short-term interest rates. The weakness in the dollar over the last two months was caused by the Federal Reserve's interest-rate cuts in September and October.
Underlying economic fundamentals in each respective currency zone also affect exchange rates, since they have an impact on market interest rates as well as policy interest rates. Speaking very broadly, a lower currency value can reflect concern about the business outlook for a particular country.
This analysis holds reasonably well for the dollar-euro rate. But what's the story with the Japanese yen?
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The domestic Japanese economy is near-comatose and has been for 15 years. You probably remember a lot of unpleasantness about an asset bubble over there, which happened when the Reagan Administration forced Japan to allow the yen to almost double in value against the dollar. (Back in the mid-Eighties, every day had a news story about how the strong dollar was killing US exporters and allowing Japan to steal all of our precious manufacturing jobs.)
To address the economic coma that followed when the bubble popped in the early Nineties, Japan's government went on a multiyear binge of deficit spending. If you thought we build "bridges to nowhere," take a look at some of the insane projects they've built in rural Japan. They now have by far the highest national debt in the world, more than twice as high as ours as a percentage of GDP.
Didn't help. Nothing has helped. Not even real interest rates that are by far the lowest among large economies, and at times have even been negative.
Today, like every major economy in the world except the United States, Japan is suffering the effects of inflation, showing up mostly in commodity and food prices. As in Europe, this makes it hard for the Bank of Japan to lower interest rates, although the BoJ actually would prefer to increase rates from their current 0.50%. (The comparable policy rate in the US, after two cuts, is 4.50%, and the euro rate is 4%.)
As in most Asian countries, Japan's banking and financial systems are not quite squeaky-clean. The BoJ isn't as independent as a central bank ought to be, and they regularly come under political pressure to keep interest rates low. This was especially in evidence in the last few months as the country went through one of its periodic political convulsions.
All of this results in an intriguing financial phenomenon called the carry trade. You can think of it as an interest-rate arbitrage. Typically, you go to Japan and borrow a lot of money at their microscopic interest rates. Then you turn around and go to a high-rate country like Australia, New Zealand, South Africa, or Iceland and lend it to the local government or businesses. You put the interest-rate differential in your pocket and life is good, so long as the relative exchange rates remain favorable.
Remember, when you unwind the carry trade, you have to buy yen at the current market rate in order to repay what you borrowed. If the yen has strengthened in the interim, you're in a lot of trouble.
No problem, there's such a thing as financial engineering. You simply hedge your currency exposure with derivatives. Ok, that works. Except in times of high market volatility, which makes options much more expensive. And guess what? We're now in the longest period of extremely high volatility that I can remember.
Bottom line, the carry trade has been less attractive than usual on most days for several months now, and this adds upward pressure to the value of the yen.
So even though the domestic economy in Japan is generally weak (there have been a few signs of strength recently), the bias in the yen is not as weak as it might otherwise have been. Combined with the perfect storm that has been knocking the dollar down, this makes life difficult for Japanese exporters.
In fact, companies like Honda and Sony that earn a majority of their profits in North America have been hit hard. As their earnings have fallen, their stock prices have taken it on the chin.
But how will Japanese companies react to this situation as a whole?
Japan is still a major exporter to China, India, Europe, and elsewhere. One doesn't normally think of flexibility as a hallmark of Japan's economy (that's more a quality you associate with ours). But there are some indications that the Japanese are successfully transitioning their export productivity away from weak US markets and toward stronger markets elsewhere.
The yen's recent strength puts Japan at a disadvantage exporting to the US (on top of decreased US demand). But this effect is much less pronounced against the euro, which has also been strengthening. And the Chinese yuan has been appreciating just a little bit faster too.*
If the trend is real and it holds up, expect the Japanese to emerge from the current period of US weakness in not particularly bad shape.
I'll close by asking a question that is something of a stretch. Risk-free interest rates in the US are now extraordinarily low across the yield curve, and in fact they're going lower. Our rates are still hundreds of basis points higher than Japan's. But is it at all possible that we are entering a multi-year period of low domestic growth, together with extremely high but easily-sustainable government deficits? In short, a mild form of the economic disease Japan has suffered from for almost two decades? If the Federal Reserve is forced to reverse their current stance and keep cutting US rates, then this case becomes credible.
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*Not nearly fast enough, of course. When the yuan was at 7.47 a few weeks back, I predicted in this space that it would strengthen to 7.4 by year-end. It's now 7.41+.
Unlike the yen-rate story, the yuan story is about international politics. The Chinese will let their currency appreciate just enough to forestall trade war, and not a bit more.
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ost US protectionism is aimed at providing stability for the blue collar workforce. Japan may be operating under the same political pressures. I'm not sure they'd be any happier with "Sam's Toyota" than they would be with a Kia or a Ford.
“The path of the righteous man is beset on all sides by the inequities of the selfish and the tyranny of evil men."
First, I'd like to address your question about whether the United States is entering a "multi-year period of low domestic growth, together with extremely high but easily-sustainable government deficits."
I've got to confess to you that I don't really understand this prognosis. It may well be that after roughly five years of economic expansion the economic is headed toward another of its periodic recessions or at least a period of much slower growth (it's certainly debateable, but Bernanke seems to think that's where we're headed and a lot of Wall Street types like yourself are saying the same thing). But you seem to be saying that what is coming could be something more than a typical 1-3 year downturn. If that were the case, wouldn't the economic downturn, coupled with the current erosion in the value of the dollar and our high national debt, impede our ability to borrow the money needed to finance the "extremely high" deficits that you project? In other words, at some point the deep well of foreign credit that we've been drawing on has to run dry, right? And in that event, we'll simply have to cut spending in order to reduce deficits to more manageable levels. Or am I missing something?
Furthermore, it seems to me that the relative weakness of the dollar should have at least some upside for American manufacturers and exports (which may, perhaps, mitigate the effects of the coming economic downturn). After all, foreign goods aren't just becoming more expensive because of the dollars decline, American goods should be becoming cheaper relative to our competition. In other words, is the decline in the dollar really uniformly bad for us, or isn't there an upside to it?
BTW, I enjoyed this diary and I'm recommending it.
Hang all traitors and secessionists! Hang them high!
- Me
..... wouldn't the economic downturn, coupled with the current erosion in the value of the dollar and our high national debt, impede our ability to borrow the money needed to finance the "extremely high" deficits that you project? In other words, at some point the deep well of foreign credit that we've been drawing on has to run dry, right?
The key question is this: Which is larger, the percentage increase in GDP or the percentage increase in the cumulative national debt. Right now, the annual deficit is declining and the last report on GDP was a growth rate of 3.9 percent.
So, in that case, the "deep well of foreign credit" probably wouldn't run dry.
Let's face it. Investors like investing in a country that is enjoying economic growth and isn't up to its eyeballs in debt. "Ah, but the US is up to its eyeballs in debt," you say?
That's when one must ask the typical econimist's question: Compare to what? France and Japan have much higher Debt/GDP ratios than the US does. In France, you've got 9 to 10 percent unemployment and it has been that was for quite some time. Japan has a low unemployement rate, but the demographics don't look that hot.
If you are an investor, where's the best place to put your money? Investors in US treasuries aren't going to sell those assets and put the cash in desk drawer. They will only sell US treasuries (or not repurchase them when the debt period comes due) if they see other investment opportunities which they like better.
And let's not forget that we recently saw very high productivity gains in the US economy too. Higher productivity means that you can produce more goods and services with the same number of people. That has to be reasonably positive, in the long run, for wage growth and profits. So far, we haven't seen a drop off in disposable income, something we usually see when we are headed into a recession.
Unfortunately, everyone in the world is missing it too.
What we're all missing is: why on earth are interest rates so low? They're now unaccountably low in the US, and they're quite a lot lower elsewhere in the world than would be expected.
Yes, the US government has been borrowing huge amounts every year since early in the Bush Administration. Econ 101 says that demand for any commodity (including money) pushes up its price (which in money's case is an interest rate).
And yet the yield on the 10-year US Treasury note just fell below 4.10%. I admit I'm a yield-curve geek, but that's just plain shocking to me.
My point as it related to a comparison with Japan is this: what if US Treasury rates keep falling, across the yield curve? The fact that no one really understands why this is happening doesn't make trend any less powerful. (Well, of course I know the proximate reason: so-called flight-to-quality. But then you have to ask why global investors are being so risk-averse.)
If long-term rates fall a lot more and stay low, then the government will have no trouble funding exorbitant budget deficits indefinitely, sa Japan does.
And with Democrats set to increase their power, you better believe that will happen. I really dislike the poor fiscal discipline that this encourages.
Investors are forced by circumstance to look at comparative, not actual, fundamentals. In other words, You, I and Thee who read the above thread all agree the US is stoopid to spend too much. So do people who know this stuff way better than I claim to.
What we didn't factor in, and why people the point on those intrest rates, is that Uncle Sam and the Land of The Cherry Blossum get a partially unearned discount for two reasons.
1) Most of the rest of the world is too inherently unstable to put your cash in. Assuming very smart bankers in Pakistan tried to set up a Federal Reserve Bank, who's to say whether those bankers would all be dragged forth and hanged 3 months from now. The worst that may happen to Helicopter Ben is having Paul Krugman say mean things about him. Oh the humanity.
2) Most of the rest of the world sucks worse at economic management and is piling up a much heavier debt to GDP ratio than either the US or Japan. t sort of reminds me of a bad High School football game where the QB who chucks the fewest INTs wins. FOr now, we and the Japanese are chucking fewer balls to the other team.
“The path of the righteous man is beset on all sides by the inequities of the selfish and the tyranny of evil men."
I understand your basic point to be that economic policymaking everywhere but the US and Japan presents risks due to market and regulatory immaturity. If you add Europe, Canada, Australia, Switzerland and a handful of others, I can more or less agree with that. And a few other countries, like Brazil, come pretty close to well-managed.
The other key theme in the interest-rate picture is globalization. Whatever your feelings about how long the current globalization trend will last, I don't think there's any question that its effects have been powerfully disinflationary. That reduces the market-risk that debt investors need to be compensated for.
... that force me to realize that I am a total and complete dope when it comes to all matters relating to money. Then again, all I need do is look at my checkbook to come to much the same conclusion.
Nicely written, blackhedd. So well done even I could almost understand where you were going!
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Diplomacy is the art of saying 'Nice doggie' until you can find a rock.
Since my main exposure to the yen concerns spare parts for the Toyota, so I don't have to worry about your "hex effect" this time.
As Arkie Liberal points out, Japan is facing some massive demographic issues- a stagnating birth rate and a rapidly ageing population. As ethnic homogeniety is valued in Japan, immigration is not an answer.
Just a thought- RS should establish a scholarship that willl award selected Ronulans the chance to travel to Japan and observe the effects of the low inflation (deflation in some years) that they seem to esteem so highly.
I can't imagine what the country would suffer if we spent 15 years in an economy where even negative fed rates wouldn't get growth going.
That said, I don't think we're really going in that direction.
Socialism doesn't work. It looks nice on paper, but it's been tried and it's failed miserably every time (usually accompanied by widespread death and suffering).
Proud member of the V.R.W.C.
I'm with Fred!
The most important reason why not is because our banking system is far more transparent and market-responsive than Japan's is. When the Japan bubble burst, the whole country was littered with credits that had been secured by overinflated assets.
In America, if your name is on a total screwup like that, your employer takes a big hit to earnings in the current quarter. And you get fired, take a one-month vacation, then hire on at some hedge fund at ten times your previous compensation.
But in Japan, you're expected to seriously consider suicide. That's why people don't ever fail in Japan. They just carry their non-performing loans on the books for years, where they inhibit the formation of new credit.
Having said all that, I'm getting intrigued with the thought that the underlying dynamic (post-bubble, low interest rates, low growth outlook) is in some way similar.
Isn't the important statistic not overall change in GDP, but GDP per head? That is, the population in the US is growing, while Japan's is not. So, 2 decades of flat GDP in the US would mean a fairly sharp decrease in GDP per head.
On the other hand, slow growth to me is less a danger than stagflation. I'm old enough to remember the Carter administration, and I don't think anyone wants a repeat of that. Alas, at least some of the pieces are in place for that. One big difference between now and the 70s is more economic integration, which may decrease the risk of stagflation.
Also, isn't it likely that Japanese business have anticipated much of this, which is why they've relocated much of their manufacturing to the US, avoiding the risk of a depreciating dollar? And while I don't think Ford and GM will be selling cars to Japan anytime soon, might it be possible for Toyota to sell US manufactured cars to Japan?