18th March 2011 by Shaun Richards
Last night saw some extraordinary moves in financial markets. In terms of underlying news the situation in Japan and in particular her nuclear reactors at Fukushima Daiichi continued to show signs of deterioration. As I wrote yesterday I feel that if you consider Japanese culture and how they behave the fact that the Emperor spoke publicly was very significant and I am afraid also rather ominous. Just to add to the bad news the forces of Colonel Gaddafi declared that civilians should leave Benghazi at ten pm UK time if they were near any rebel forces. And the situation in Bahrain continues to show signs of increasing rebellion followed by stricter crackdowns. In the middle of all this the Japanese Yen shot higher on foreign exchanges and the Japanese Nikkei 225 equity index was called one thousand points lower with a couple of hours to go before its opening. The Nikkei 225 in fact opened some 300 or so points lower but recovered somewhat and closed 131 points lower at 8962.
What happened to the Yen versus the US dollar?
At first we saw what at the time seemed quite a significant event as the Yen strengthened and went through its 1995 high of 79.78 against the US dollar as it pushed through the 80 level initially to the mid 79s. In itself, an all-time high versus the US dollar is significant enough as if you look at my category for Japan’s economic crisis on this blog you will see that I often discuss how Japan’s rallying Yen has made life more and more difficult for Japan’s exporting industries and even lead to a monthly trade deficit recently. However then in a fevered atmosphere the Yen shot higher passing through 79 and then 78 before peaking at 77.18. The atmosphere was so fevered that I am using figures from the Financial Times as others are claiming that in fact 76.25 traded! I suspect that may be what is called a high-tick (where someone deliberately pays too much for something to get that price to trade…).
This morning the situation has calmed down with the Yen exchange rate falling back into the 79s for a while. However as I type this I notice that it has dropped again and is now at 78.96. If last night had not happened this would be seen as a very significant move and it would be an all-time high. The Yen also rose strongly against other currencies and I will return to the significance of this in a moment.
Why is this particularly significant? The carry trade
Back in the middle of the last decade there was a period where “the carry trade” was very significant and let me quote from my article on the 24th of December 2010 explaining what it is.
One of the factors that has led to the distress of recent years has been the carry trade. For those that are unfamiliar with it let me give an example of how it works. If you do it the interest-rate in your own currency will be higher than the interest-rate of the currency you intend to borrow. For example the countries whose currency was most borrowed for this purpose Japan and Switzerland had low interest-rates in the middle of the last decade whereas many parts of Eastern Europe had high single figure interest-rates. Accordingly each year there is an interest-rate or carry profit and in some cases this was fairly substantial.
The numbers quoted there refer mostly to the Swiss Franc carry trade so I have looked up some data for Japan. If we go back to 2005 the official Japanese interest-rate did not rise above 0.1% and it has not been above 0.5% for quite some time. Now if we look at official interest-rates in Australia between 2004 and 2006 they were either 5.25% or 5.5% before rising over time to a peak of 7.25% in early 2008. As you can see there is quite an interest-rate saving in borrowing in Japanese Yen rather than Australian dollars. So investors did and they did so on a very large-scale and Australia is only an example there were many others to whom this applied. Even for a trading nation the size of Japan the enormous size of currency investments based on this carry trade dwarfed her economy,trade flows and currency.
This requires a little bit of mental dexterity but if others borrow in your currency then it is depressed (it is the reverse of them buying it…). So the carry trade drove the Yen and the Swiss Franc lower and if you think about it this will have encouraged more investors to do this trade as not only did it have annual interest-rate gains but it started to look like there were capital gains to be had too. If it seems to good to be true then you are getting the picture but for a while this did work rather well. Those who really profited from this would have been those who remember the financial market aphorism “there are the quick and there are the dead”.
How did the Carry Trade go wrong?
As I have just pointed out it became too popular and swamped the Japanese economy/currency let alone the much smaller Swiss economy/currency.The obvious problem is that as ever more were attracted to the scheme the problem of an exit strategy got worse. How could this ever be reversed without having the effect of raising the value of the Swiss Franc and Japanese Yen ? The answer is that it could not and in fact has been taking place recently when the Swiss Franc and Japanese yen have been strong due to theirs safe haven status (I know with the earthquake and tsunami this is an irony for Japan).The error was the size of the trade which was much too large for the size of the Japanese Yen exchange rate market let alone the Swiss Franc.
I am sure that some were encouraged to borrow more as monthly repayments under such a scheme would be much lower than before. If you think of a mortgage affordability calculation under the new lower interest-rates the possible implications become plain.
There are considerable implications for the countries whose exchange-rate has been borrowed and the smaller the economy the more likely it is that it will be swamped. They find that their currency is artificially depreciated at one phase of the arrangement and later artificially appreciated at the final stages.
So where are we now?
If we concentrate on Japan we can see that her currency appreciation in 2010 and 2011 was probably driven by some investors unwinding their carry trades as they spotted that world events were making the Yen stronger. As you can see this is something of a self-fulfilling arrangement and it pretty much describes why the Yen has been so strong. Now we have another factor which is that Japan has very large savings abroad and with her obvious need for reconstruction foreign exchange markets feel that she is likely to repatriate money to help with this.This is what she did after the Kobe earthquake in 1995. As an example of the sums involved Japan’s government is estimated to have just under US $ 900 billion in US Treasury Bonds.
There is a debate going on right now as to whether Japan actually is repatriating funds or not but I consider this to be rather academic as the real issue is whether markets think she might. As it happens the Yen is often strong at this time of year as Japanese companies tend to repatriate funds ahead of the end of their financial year. However some parts of the media try to spin the story a strengthening Japanese Yen is not good for Japan right now and those suggesting that it will help against inflation appear to be unaware that Japan has not got any!
Why has the Bank of Japan not intervened to weaken the Japanese Yen?
If you have been wondering this then so am I! Put another way I am not a fan of exchange-rate intervention as I have argued before and I wrote this back on the 15th of September 2010 when the Bank of Japan intervened at 83 to the US dollar.
Whilst the intervention has had a short-term success we are so far only measuring its impact in hours. Over time I expect the foreign currency markets to challenge the willingness of the Bank of Japan to weaken its own currency.
Pre-earthquake this is pretty much what has gone on with the Yen ebbing and flowing but not weakening as the Bank of Japan would have hoped. Now with the earthquake,tsunami and reactor problems the Yen has surged again. Let me be clear the Bank of Japan cannot be expected to have known about them but in my view this natural disaster does again show us how central banks have over-extended themselves and become vulnerable to “expect the unexpected” events. Yet oddly at a moment when intervention might have had a success the Bank of Japan was nowhere to be seen. Short-term movements caused by a natural disaster are one of the situations where foreign exchange intervention can help in my view and are a valid policy option. Indeed if I was in charge of a foreign central bank I would intervene and help too and concerted intervention is the most likely to have an effect.
Psychology and markets
This is difficult to measure as we are into opinion and looking into the human sub-conscious. However the fact that the Yen has risen to nearly 77 against the US dollar tends to set a new trading range in the human mind and we have a new landscape which before last night was not there. Put another way the spilt wine is out of the bottle. For those who look at this as a chart and do technical analysis we are into uncharted territory (sorry) and accordingly some forecasts now will be of a further substantial rise.
The Swiss Franc
I wrote an article back on the describing the Swiss Franc and Japanese Yen as “currency twins” because if you look back in time their behaviour has been similar. Whilst today’s article has concentrated on Japan I wish to point out that the Swiss Franc has been strong again too and is currently at 1.26 verus the Euro. The 1.7 million Hungarians who have a mortgage denominated in Swiss Francs will see their mortgage rising again as the Swiss Franc hits 219 dinars.
I wrote a month or two ago that the Chairman of Anglo-Irish Bank had reported that he felt that the 35 billion Euros set aside in the EU/ECB/IMF rescue plan would not be enough and more would be needed . This was officially denied and the official view was that only 10 billion would be required and that the reserve of 25 billion would not need to be touched. Now I notice that the new government is weakening on its predecessors position and I expect a much higher figure to emerge. The new Finance Minister Michael Noonan has openly said that he feels that 10 billion Euro’s will not be enough.
So Ireland’s previous administration will go into the history books with one more example of it misrepresenting the truth and we have an explanation of why Ireland’s ten-year government bond yield is at 9.76% i.e higher after the “rescue” rather than lower.