Two of the most important features of the yen currently are a decline in the carry trade and a more bearish outlook for the Japanese economy. Both tend to strengthen the yen, as Japanese investors unwind their short yen positions in the first case, and Japanese foreign direct investment retrenches in the face of higher risk in the second case.
Even the high probability of rate hikes in the US later this year will not necessarily drive the yen lower û in the past, the dollar has risen against the yen ahead of the rate rises, only to level out or decline subsequently.
ôOn average, the dollar/yen starts appreciating 20 weeks prior to Fed rate hikes, with an average magnitude of 6.1%. From the current level, dollar/yen could appreciate 2% more by September. After the Fed starts hiking rates, dollar/yen declines 7.3% in 25 weeks,ö says Sasaki.
The outlook for the yen is important, given some surprising moves. Since early March, dollar/yen has strengthened dramatically, from 97 to 109. The rise follows a long period of extreme weakness, which Sasaki blames on super liquidity in the Japanese financial system that is driving down interest rates and, in particular, volatility.
ôWhen volatility was very low, the carry trade made good sense. With higher volatility, as now, the carry trade is less attractive,ö he says, ôand that puts upward pressure on the yen.ö Higher volatility is the by-product of uncertainty in the credit markets and Western financial institutions, he says.
Expectations on yield differentials are drivers for all currencies, including the yen. But a resumption of the carry trade and a weakening yen are less likely when other countries do not show strong expectations of changes on policy rates. Expectations of rate hikes are strongest in the US, but the real policy rate there is very low. Real policy rates are the highest in New Zealand, but its central bank is expected to cut rates.
Differentials between the US and Japan are only 150bp, which is well below the 425bp level when the carry trade was most active at the end of 2005. Even with the expected rate hikes, JPMorgan economists only expect rate differentials to widen by 200bp by March 2009, says Sasaki.
Sasaki also believes the dollar will not be a very strong currency thanks to the country's current account deficit and its increasing inability to attract inflows from abroad. A current account deficit normally puts weakening pressure on the currency as importers sell off their currency to buy goods. But America has been able to counter that weakening pressure through forex inflows into its stock and bond markets. This has propped up the exchange rate.
The first shock to those inflows was the end of the tech bubble in 2001. After the bubble collapsed, inflows collapsed too. They resumed strongly by 2003, but the subprime debacle has caused levels to weaken. Sasaki says the weakening of inflows have a clear correlation to the tumbling dollar, which has dropped from 106 at the peak of the tech bubble. At that time, inflows were close to $150 billion per quarter, compared with net outflows of almost $100 billion in the first quarter of this year.
In addition, despite the prospect of Fed rate rises, inflation in the US means that real rates will still be negative. Rising inflation coupled with the downward pressure on the US dollar could rapidly erase the strengthening of the currency that has occurred since March. Sasaki therefore concludes that dollar/yen is unlikely to see any substantial changes in its fundamental relationship soon. The yen is still affected by the low interest policy introduced in the wake of the bubble, and the dollar has to deal with substantial US economic weaknesses.
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