The Titanic Yen

WED 22 JUN 2022

The rally in the US dollar and depreciation of the Japanese Yen has become episodic. Clearly it has not gone unnoticed and is now the focus of a single story on Bloomberg. As we have often noted, phases of rapid and emotional appreciation in the dollar can often be associated with challenging periods for risk assets. Of course, dollar appreciation in the current episode has primarily been relative to other fiat currencies given the nature of the episode in commodities.

The depreciation of the Japanese yen has now reached the weakest level since 1998 (chart 1). As an aside, the Titanic was released in December 1997. While that was probably peak Kate Winslet, I loved the later work of DiCaprio with Tarantino. For markets, the large depreciation of the yen was followed by an equally rapid and emotional appreciation into the LTCM crisis. The big picture point is that although yen weakness has been warranted by the negative terms of trade shock (Japan is a large commodity importer) and the Bank of Japan’s misguided insistence on maintaining the policy of yield curve control (capping the 10 year JGB yields at 0.25%) it can lead to an equally violent reversal in a phase of risk aversion.

On face value a large depreciation of the yen might help the Bank of Japan achieve higher inflation (chart 2). However, it is not obvious that the ensuing inflation is desirable or sustainable, especially there is an equally episodic appreciation of the yen into a financial market or economic shock. A key question is whether the BOJ’s policy of yield curve control is still appropriate and also whether they are capable of maintaining the target, given the purchases are approaching 50% of GDP?

In theory, a country that has its own central bank and currency can purchase an unlimited amount of bonds. In practice, the currency might be the ultimate constraint if there was a further disorderly depreciation of the yen and a large reflexive rise in imported inflation. Put another way, a break in the yield peg could be triggered by the currency (and pegs always break).

Our point here is not to recommend fading yen weakness in the near term. Currency markets tend to extend moves much further than most participants can imagine. However, it is important to note that the Japanese yen is around 30% undervalued on a real effective basis (that is, its trade-weighted exchange rate adjusted for inflation). Moreover, 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. The Japanese yen has often been the tip of the market iceberg.