June 26: Risk Alert: Japan's Policies Could Ignite FX Risks, Strengthen Dollar/Yen
Erik Helland Tokyo
Risk managers beware: currency analysts are telling traders to buy dollars and sell yen, based on evidence that Japan?s government, which should remain intact following the election, lacks sufficient evidence of an economic recovery. The news will not catch most risk managers and asset managers, who have either structuring asset allocation strategies that are neutral to Japan?s economic situation, or will adjust their portfolios in a manner equivalent to scenarios developed specifically for movements in Japan. However, what risk experts say they are more worried about is the systemic risks that could emerge if Europe?s possible inflationary pressures create instability for the euro against the yen.
Currency analysts are projecting the dollar to hit 108 against the yen in the near-term, and 110 on longer maturities. They contend that traders will sell yen at these levels based on three reasons: the Bank of Japan doesn?t have enough evidence of an economic recovery to raise rates this summer; the election this weekend won?t change much in terms of Japan?s fiscal policy; and the Japanese don?t want the yen to rise through 100.
Japan?s government officials have issued statements that support this contention. One Ministry of Finance official said that there is no reason for the yen to strengthen, based on the stronger economic fundamentals in the U.S. and Europe. Another Ministry of Finance official added that Japan will take action in the foreign exchange markets when appropriate.
?In essence, the intervention shark is circling,? said a risk official in Boston. ?There is a risk that the yen probes a bit higher yet. For the risk averse, we?d recommend moving into a position in chunks. But the yen is now in the sell zone.?
Some risk sources contend, however, that Japan?s Ministry of Finance will use the yen?s strength as a stick to prevent the Bank of Japan form raising interest rates this year. If true, then the dollar is likely to remain offered against the yen for months, keeping it in a 102 to 106 range.
So, why is the yen strong? Risk sources say that despite Japan?s economic woes, the government isn?t recycling its currency account surplus. As a result, the combination of an extremely loose fiscal policy, and an extremely tight monetary policy, tends to fuel currency appreciation.
?It may be counterintuitive to think that zero percent rates ? the Bank of Japan?s policy for over a year ? is loose,? said a risk official. ?But in real term, it is. In fact, the gap between Japan?s CPI and the (Bank of Japan?s) benchmark overnight rates is near its high of the last three years at 0.82, versus a low of ?2.00 in October of 1997. Not surprisingly, Japan?s growth was a lot better then than it is now.?
In short, interest rates work. The cure for Japan and the strong yen is for the BOJ to print money and create inflation, according to a risk source. The only problem is that the BOJ has no interest in pursuing this policy. Conclusion ? there are structural reasons for the yen to be bid against the dollar but we don?t see these pushing the yen much higher from here.
riskcenter.com
Why Is the BOJ Itching to Raise Rates?
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