Old habits die hard as nervous investors flee to the yen

By:
Solomon Teague
Published on:

The Bank of Japan (BoJ) has worked hard to weaken its currency in recent months and had achieved some considerable success with its quantitative easing (QE) programme, with yen levels at their weakest against the dollar for more than a decade. The global panic after China’s devaluation of the renminbi saw the yen quickly bounce back, but authorities are unlikely to give up.

yen banknote-R-600


When risk aversion spiked in August, after China’s devaluation of the renminbi, the result was an all-too-familiar flight to safe-haven currencies.

Kit Juckes, macro strategist at Société Générale, says: "The August winners in FX-land are the currencies of countries which import oil and have the least scope to ease monetary policy further, or at least those where there is the least scope to surprise markets with further easing."

G10 v USD
G10vsUSD_SG
Source: Société Générale
Exhibit A: the yen. The hammering of the global equity markets and general decline in risk appetite has seen yen outperform other G10 currencies in recent weeks, registering a near 3% rally in August against the dollar.

Having traded as low as 125.9 at one point in August, its lowest value since 2002, the yen has more recently hovered around the 120-mark against the dollar, and also strengthened against the euro.

In fact, August was the most volatile month for the currency since February 2009, says Eric Theoret, FX strategist at Scotiabank. USD/JPY declined 6.0% on an intraday basis, registering its high on August 21 and its low on August 24, in response to panic fuelled by a rout in the equity markets and the broader problems emanating from China.

The Commodity Futures Trading Commission net-short position narrowed by $6.4 billion to $4.1 billion through the two weeks ending August 25, he says.

Heightened volatility

This heightened volatility reflects the fact the yen has been under pressure from external and internal factors, but clearly external factors were the principal driver. On the face of it there is nothing surprising about this: in times of global risk aversion, investors have traditionally retreated to the familiar sanctuary of this Asian safe haven.

However, the BoJ will be disappointed to see all the work it has done with QE to weaken the currency undone at a stroke. The question now is, with uncertainty still rife about the forthcoming decision on rates from the Fed, and the outlook for the Chinese economy, is the yen set for further strengthening?

Conventional wisdom would suggest so.

Daiju Aoki, economist at UBS, says: "If a slowdown in the Chinese economy triggers a risk-off global market, the yen is likely to be bought as a safe asset, leading to yen appreciation against the renminbi, alongside appreciation against the dollar and euro."

However, Aoki believes the BoJ will do what it can to re-establish yen weakness if market sentiment continues to push up the yen.

Takahiro_Sekido-160x186
Takahiro Sekido, BTMU
Takahiro Sekido, Japan strategist at Bank of Tokyo-Mitsubishi UFJ (BTMU), concurs, adding: "We doubt yen gains will be sustained and given the degree of BoJ monetary easing and the need for the yen to remain weak, we expect strong support for USD/JPY to ensure limited further declines from current levels.

"Our sense is that the scale of the move reflected positioning and that once positioning becomes more neutral, the upside for the yen will become much more limited."

If global market sentiment pulls yen one way, and the BoJ endeavours to pull it another, the outcome is likely to depend on the scale of the crisis creating the risk aversion.

"In the case of a serious crisis from China, akin to the financial crisis, the BoJ and ministry of finance might not be able to stop yen appreciation," says Aoki at UBS. "But this is not our main scenario."

So far, the BoJ has kept its monetary stance broadly unchanged, maintaining its commitment to raising the monetary base by ¥80 trillion annually, but BTMU’s Sekido believes market turbulence will force the BoJ back to the monetary-easing table.

 USDJPY.png
Source Scotiabank
It is not just the turn in sentiment that will concern the BoJ. China’s fortunes have a direct impact on Japan, especially via trade, with China taking more than a quarter of Japan’s total exports – or around 18% on a value added basis, second only to the US.

Aoki estimates "a 1% slowdown in China’s real GDP growth would depress Japan’s real GDP by about 0.3%, mainly as the direct impact is compounded by the indirect impact via third countries and by forex."

Internal factors have also contributed to yen volatility. Real GDP contracted by 0.4% quarter-on-quarter in Q2. Private consumption fell 0.8%, while inventory build-up suggests growth might not rebound quickly, even when consumption picks up.