The Year of the Yen
by Ashraf Laidi
2/8/2005, Forexnews.com
2004 may have been known as the year of the euro. 2005 might as well be the year of the yen, or at least the beginning of the yen’s long awaited bull run. Rationale: Japanese authorities cannot afford stacking their $700+ billion chest of US treasuries when the dollar is expected to shed more of its value after an 18% decline in trade-weighted terms over the past 3 years. A gradual Japanese retreat from US dollar securities into non-dollar assets is inevitable in order to avoid massive losses on the central bank’s US dollar portfolios.
Dollar losses are not only confined to Japan. The European Central Bank is expected to take a loss of at least $1.3 billion on its US dollar holding as a result of the euros appreciation against the US currency. The ECB had already booked a $625 million loss in 2003 due to the falling dollar. The People’s Bank of China has the second biggest armory (after Japan) of foreign exchange reserves at $600 billion in 2004. The NY Federal Reserve estimates that a 10% rise in the Chinese yuan would trigger a drop of about 3% of the nation’s overall GDP. Several central banks have started the adjustment process into euros since 2 years ago. Russia already began shifting its currency within the past two years from 12-15% holdings in euros to 25%. A move to 50%-50% dollar-euro proportion is inevitable.
Japan see no choice but to follow suit. Leading the world in holdings of US treasuries amounting to $715 billion in November, Japan loses $7.2 billion for each yen lost against the US dollar. A drop to 97 yen from 103 would inflict a $43 billion hole in Japan’s portfolio of US assets. That explains the drop in Japanese holdings of US treasuries between September and October of last year--the first month-to-month decline in three years. See chart below:
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Japan should especially start lightening its hand from US assets before China initiates the fray when it eventually revalues its currency and sees less of a need to purchase US dollars in intervention over time. Despite mounting pressure from Europe and the US to revalue the yuan, China isn’t likely to succumb to these demands and compromise its economic engine for the sake of prematurely liberalizing its financial markets. We expect China to follow up on last year’s rate hike so as to contain inflation at its implicit 5% target and to avoid policy over-stimulus. Only a successfully implemented revaluation—likely in Q1 2006-- could then lead to a subsequent 2-3% upward move with a similar band, thus creating a crawling peg currency regime, i.e. periodic revaluations thereafter. This would pave the way towards an eventual basket peg, whereby the yuan is pegged against the dollar, euro, yen, Aussie and a few other Asian currencies. Such an arrangement would be most ideal for avoiding sudden fluctuations, which are more typical of single currency pegs, especially with China’s disparate trade balances against the currencies involved.
It can be argued that Japan cannot tolerate any more yen strength beyond the 100-yen level against the dollar. But Japan’s deflationary spiral since 1998 implies that the real dollar/yen exchange rate has in fact depreciated, thus a 100 yen in today’s terms is nearly equivalent to 110 yen about seven years ago. And considering the surge in Japanese foreign direct investment into China’s manufacturing lab, Japanese companies have grown increasingly hedged against a rising yen as they use China as an export base.
With China’s trade accounting for 20% of Japanese total international trading transactions--overtaking the US as its largest partner--Japan is growing more dependent on trade with its own continent China and relatively less on the US. A dollar depreciation of about 10-15% could be more damaging to Japan’s portfolio of US dollars than on the balance of sheets of some Japanese exporters. The strain on exports via a falling dollar/yen rate could also be cushioned if China revalued and allowed its currency to appreciate against the yen.
Short Dollar/Yen and 1/2 Long Aussie/Yen
The ongoing absence of the Bank of Japan from the intervention circuit combined with improving prospects of a yuan revaluation is a bullish opportunity for the yen, especially when markets expect Japan’s inflation to regain positive territory after 7 years in the red. As long as China continues to defer a revaluation, shorting the dollar/yen rate remains more attractive than shorting the euro/yen as the euro continue to absorb the dollar weakness. The 100-level in dollar/yen remains the preliminary target, followed by 97 in Q3. We recommend hedging this strategy by taking a long position in AUDJPY with a magnitude ½ the size of the short in USDJPY. The Aussie position should payoff as long as the yield differential remains sustained--especially amid revived chances of an Aussie rate hike. Long Aussie would also proves rewarding in the event that a renewed oil bounce weighs on Japan’s prospects.
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- February 8, 2005.
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