Japanese Yen: Be Careful What You Wish For, Consensus...

Conclusion: History shows us that G7 intervention to weaken the yen has resulted in a significant uptick in inflation within Japan. In fact, if the G7’s plan to weaken the yen is “successful”, we expect the inflationary impact to be even greater this time around, particularly given Japan’s current staggering sovereign debt load and easy monetary policy.

 

Positions (TREND duration): Bullish on the yen and bearish on equities; OR bearish on the yen and JGBs. Getting ahead of the whims of central planners will be key to isolating the winning strategy here.

After just over a decade of inactivity on a collective scale, the G7 jointly intervened in the global currency market to help the ailing Japanese economy by weakening the yen, which is down nearly (-2.3%) on the day. In addition to today’s centrally-planned intervention, the G7 promised additional support as needed:

“We will monitor exchange markets closely and will cooperate as appropriate.”

In spite of yet another round of Almighty Central Planning perpetuating unprecedented volatility in yet another market, we remain positive on the yen over the intermediate-term TREND for now. That could change. While today’s intervention may have cooled off the speculative bid for yen appreciation (net yen shorts of Japanese households dropped -30% day/day), the fundamentals – repatriation and compressing interest rate differentials leading to unwinding of carry trades – remain supportive.

The expected acceleration in JGB issuance in the wake of this crisis (which, coincidentally, pushes Japan’s sovereign debt load above one QUADRILLION yen) has to be financed somehow, which is one of the supportive factors for the repatriation case (in addition to risk aversion and the need to finance rebuilding efforts).

Of course, the Bank of Japan could continue to provide “powerful” and “massive” stimulus, as pledged by BOJ governor Masaaki Shirakawa. They are currently already monetizing JGB debt at a rate of ¥21.6 TRILLION ($267.2B) yen annually, so what’s another ¥10-20 TRILLION yen in perpetual debt monetization?

The last time the world’s Almighty Central Planners decided to collectively intervene to weaken the yen as on August 15, 1995 (about a half a year after the Kobe earthquake). The yen went on to weaken (-29%) over the next three years until a reversal of that intervention scheme on June 17, 1998 sent the yen sharply in the other direction.

As with any Fiat Foolery throughout the course of history, the resultant yen weakness was accompanied by unintended consequences, as the deliberate currency devaluation resulted in a sharp spike in reported inflation on the island economy. As always, there are two sides to every trade.

The chart below shows YoY growth in Japanese Import Prices swung +1,860bps in the year following the initial intervention (July ’95: -3.5% YoY vs. July ’96: +15.1% YoY). In the 18 months beginning in Jan ’96, Japanese Import Price growth averaged +10.4% YoY. Eventually, these higher input costs manifested their way into reported inflation throughout the Japanese economy, with Japan’s Nationwide CPI peaking at +2.5% YoY in Oct ’97 vs. a deflationary (-0.6%) YoY just two years prior – a +310bps swing.

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This history lesson begs the following questions with regard to the current round of intervention:

Can the Japanese government’s stained finances handle backup in interest rates? Debt Service already consumes ~45% of the central government’s revenue.

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Can the Japanese consumer, after many years of price and wage deflation handle higher prices?

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Can Japan, which will need to procure raw materials from abroad to rebuild in the wake of the current disaster, afford an acceleration of imported inflation brought on by currency weakness?

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Can Japanese economy handle higher inflation, period? We don’t think so. This is why we stand counter to the current sell-side storytelling about “accelerated growth driven by construction and yen weakness”. The playbook for where Japan may be headed as a result of this current round of Big Government Intervention has a lot more factors than consensus’ simple two-factor, “buy the dip” model.

In fact, BOJ governor Shirakawa agrees, saying today that the government wants to avoid abruptly weakening the yen because it may bring about a back up in JGB yields. “That’s naturally the biggest fear for the government”, he says.

A worthy fear indeed.

Darius Dale

Analyst