Like a Wrecking Ball

THU 09 JUN 2022

The impulsive rally in the US dollar over the past year has once again highlighted its role as a wrecking ball for risk assets. To be fair, dollar appreciation has been relative to other fiat currencies not commodities given the nature of the current episode. The recent price action of the Japanese yen has also been rapid and emotional. Yen weakness is an obvious reaction to the negative terms of trade shock (Japan is a commodity importer) and the Bank of Japan’s (misguided) insistence on maintaining the policy of yield curve control (capping 10 year JGB yields at 0.25%).

The European Central Bank meeting today also appears likely to be one of the most interesting for some time. Dollar strength relative to the euro has also been a function of the ECB’s dovish policy. However, with Euro area headline inflation at 8% and commodity prices (in euro terms) at a record high, current policy settings appear untenable. Ironically, the year over year change in commodity prices (in euro terms) might have peaked, which suggests that headline inflation may also have peaked (chart 1). Commodities are a relative price – producers win at the expense of consumers when prices rise. Nonetheless, from our humble perch, ECB policy appears entirely inappropriate in the context of current conditions even if a large part of the inflation episode has been driven by the supply shock.

Returning to the yen, the currency is now materially undervalued on a real effective basis (that is, its trade-weighted exchange rate adjusted for inflation). On that measure then yen is around 30% undervalued. As we noted above, the rapid and impulsive depreciation of the yen is likely due to the terms of trade shock and relative interest rate differentials. For markets more broadly, the troublesome aspect of a major dislocation in the yen is that it has often preceded episodes of cross asset volatility. For example; May 1997 USDJPY drops almost 15 big figures in two weeks and a couple of months later the Asian crisis erupts, June 2007 two Bear Sterns credit funds implode ahead of the 2008 crisis or more recently in mid-2015 China devalues the CNY and a major phase of market volatility erupts with the global growth scare in early 2016 (chart 2).

To be fair, as Cam Crise has noted, the yen was often a symptom of speculative excess rather than the proximate cause of the subsequent volatility. Put differently, the yen was used as a funding currency and a source of capital from Japan’s large net foreign asset position. Nonetheless, as the yen becomes increasingly unhinged, it might signal a phase of broader instability ahead. While the Bank of Japan might welcome orderly depreciation of the yen to help achieve its goals, a rapid correction could eventually lead to repatriation of capital back into domestic assets. That is more likely than a local crisis because most of Japan’s debt is still held domestically. The Japanese corporate sector also tends to benefit from yen weakness.

The big picture point is that phases of sustained dollar strength tend to be challenging for risk assets as they tend to coincide with higher dollar rates and tighter liquidity. At the same time, if there is a rapid reversal of Japanese yen weakness that could also coincide with a disorderly phase of volatility for markets.