• PM Bulletin: A look at the yen

    If you switch on Radio 4 in the evening (try and do this after The Archers) it’s usually not long before you’ll hear some talking head declare that “correlation is not causation”. The statement will generally crop up in discussions about government social policy, or a similarly dry topic. I prefer the phrase “post hoc, ergo propter hoc” which translates (loosely apparently) as “after this, therefore because of this”. I think this Latin translation is pithier and easier to understand than the Radio 4 equivalent.

    Both phrases address the fact that just because one event follows another, it doesn’t mean that the first event caused the second. Given the complexity and constant flux of financial markets it’s no surprise that analysts and commentators have to be very careful about ascribing, say, a rally in the stock market to rising oil prices. It may have been the case in the past and it may be true now, but on the other hand it might not be.

    Matters can be particularly complex when it comes to movements in FX and how these relate to other financial markets. An FX rate expresses the price of one currency relative to another and so is quite different to, say, a share priced in sterling or gold priced in dollars. And there’s one FX pair in particular which is always worth keeping a close eye on when it comes to unravelling investor behaviour and that’s the USDJPY. While the EURUSD is the most heavily-traded currency pair, it is the dollar/yen that gives the best indication of whether investors are in “risk on” or “risk off” mode.

    There are a number of reasons for this. To start with, the yen is a highly liquid currency (like the USD and euro) and is used extensively in international trade. Japan is the world’s third largest economy by GDP and one of the largest exporters in dollar terms. The yen is also the signature currency for Asia and a significant reserve currency for many Asian Pacific countries. This is despite Japan’s extraordinarily high debt levels which investors tend to discount as so much of the debt is domestically owned.

    But it is the carry-trade which is the main reason for the USDJPY’s importance in assessing investor risk appetite. Historically the differential between US and Japanese interest rates has always been wide with Japan’s far below those of the US. This makes it an attractive proposition to borrow (sell) the lower-yielding currency in the pair and use the funds in the other currency to purchase riskier assets. Of course, there are plenty of currency pairings which offer a wider and therefore more profitable interest rate spread than the USD-JPY, but no other currency pairing has the depth, liquidity and geographical spread as the USDJPY.

    So, other factors aside (such as central bank interventions) moves in the USDJPY pair tend to lead moves in US stock indices. If the USDJPY is falling (in other words the yen is appreciating) it’s usually the case that the S&P and Dow are falling and vice versa. We’ve seen this quite clearly recently when equities were coming under pressure as the USDJPY fell towards 100 and as they subsequently rallied as the yen weakened.

    It’s particularly important to keep an eye on this pair now. The USDJPY is up over 6% since Japanese Prime Minister Shinzo Abe’s ruling Liberal Democratic Party cleaned up in upper house elections earlier this month. The victory is seen as paving the way for further fiscal and monetary stimulus with much speculation focusing on the prospect of “Helicopter Money”. This would really take government/central bank intervention to a different level and would be an unprecedented experiment in policymaking which has the danger of paving the way for hyperinflation taking hold.  So the Bank of Japan’s meeting at the end of this month is particularly important. If the central bank disappoints in terms of additional stimulus then expect the USDJPY to fall sharply, along with global equities.

    David: But it is the carry-trade which is the main reason for the USDJPY’s importance in assessing investor risk appetite.

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