The Week of March 14th: Speculation and the Yen

There is a common misconception about currencies and their values which goes somewhere along the lines of - the stronger the currency, the stronger the economy. This is an incorrect view which does not consider the fact that export dependant nations necessarily need to keep their currencies weak. Even the dollar is not an exception to this rule, and one of the unstated objectives of the massive quantitative easing programs being carried out by the Federal Reserve is to weaken the dollar. This is done through creating extra supply of dollars and hence affecting the balance of payments which further affects the exchange rates.

Currently there has been a great amount of discussion in the currency markets about the sharp appreciation of the yen following the massive natural disasters that hit the country last week followed by the reactor meltdowns. The increase in the value of the Yen seriously undermines the potential for a recovery in the equity markets which have been rocked by the recent spate of disasters afflicting Japan. The Nikkei fell by over 10% on a single day this week, wiping off billions in value from the equity markets. The Japanese have always been a strong and resolute people, but even they will not be able to dig themselves out of this hole if their currency continues to strengthen. The rise in the Yen has been attributed to speculative activity by traders. The Yen touched 76.375 to the Dollar on the 16^th of March, a move that gained momentum after some heavy options book selling. This was the strongest the Yen has been since the aftermath of the Kobe earthquake when the Yen hit 79.75 to the Dollar.

Fundamentally speaking, the appreciation of the yen can be attributed to risk aversion following the earthquake. The Japanese have had to repatriate their foreign assets home in order to fulfill the needs of disaster relief and reconstruction activity. This risk aversion has been strong over the last few months in any case. The happenings in the Middle East do not make the case against risk aversion strong. Furthermore, reports from hedge funds suggest that equity hedges of up to $20 billion over January-February to insure against the weakness in Japanese equities have lead to further currency appreciation.  .

Historically the Yen has been strengthening against the Dollar in the very long term. In the late sixties, it took over 350 Yen to purchase a Dollar, and these days it is hovering around 80 Yen to the Dollar. The most recent highs for the Dollar were reached at the peak of the asset bubble in June 2007 when 124.14 Yen would buy one dollar. Since that peak, the Yen has been in a long term appreciation trend against the dollar. This trend does not seem likely to reverse in the long term despite many possible central bank interventions.

The G7 have agreed to get their feet wet in the currency markets to curb the current appreciation. The exact amount of intervention has not been clarified, and indeed it does not matter. The main effect of intervention is the effect of the announcement in the minds of currency traders. Much like interest rate announcements, such an explicitly announced intervention will be priced into the market without the need for actual significant amounts of intervention. As I type this, the Yen has weakened to 81.76 to the Dollar.

The interesting effects of currency intervention could be the creation of extra liquidity in the Japanese economy. The Bank of Japan might not absorb the extra liquidity that will be generated by the current increases in supply of the currency. The economy has been in a veritable deflationary spiral for decades, and might just benefit from the series of disasters that have struck it recently in that there might actually be some inflation in Japan at the end of the current rounds of quantitative easing. Albeit unlikely given that monetary expansion has not worked so far, this would truly be a turn around moment for an economy which has more or less stagnated since the collapse of its massive asset bubble in 1991.