The Curious Case of the Yen in the Night-Time


One of the most important events of 2016 to date was the introduction of negative interest rates by the Bank of Japan – the first major or G7 central bank to do so. Prior to the BOJ move negative interest rates had been an economic curiosity in Scandinavia or at best an act of defiance on the part of the Swiss National bank, as its sort to weaken the Franc and defend its export led economy. The BOJ actions changed that completely and the landscape of international capital markets would receive a further shake up when the European Central Bank also moved interest rates below zero, a few days later. We now have the very odd situation whereby the central banks in two the world’s largest economies are charging depositors for the privilege of banking their cash and are on the brink of paying those same depositors to take the central bank’s money away with them. If that sounds to you like the plot of a film, set in dystopian future, then you are in good company. These are strange times indeed.

A law unto itself

Japan’s economy has always been something of a law unto itself, despite strenuous efforts to iron out some of these idiosyncrasies, in the reconstruction that followed the end of WWII. Old habits proved to be highly resilient however.The Bubble economy of the 1980s and early 1990s and the corporate scandals and governance failures, associated with the bursting of that same bubble, demonstrated that resilience only too well. A combination of greed, state interference and above all a need to maintain face, left a legacy from which Japan is still trying to recover more than 20 years later.

Lab rats

In some senses Japan has been a laboratory for monetary policy experiments for the last 20 years. As successive governments tried to prevent the economy from stagnating. At each juncture the government and the monetary authorities have been prepared to countenance more extreme action. Negative interest rates, are in that context, just another roll of the dice. However from where we sit it could very much be one of their last plays.

Rewriting the theory

Economic textbooks often contain a section on the Liquidity Preference Theory of Money as developed and advanced by the famous economist and investor John Maynard Keynes. This sounds complicated but is in fact a fairly straightforward rationale, which says that money will flow towards those investments (or in this instance currencies) that offer higher interest rates and out of those investment or currencies that offer an inferior return. Though not without criticism, when this theory is coupled with the inverse relationship between bond prices and interest rates and unfettered foreign exchange, it creates an economic model that most people would readily recognize and which many of us would assume operates in the modern world.  In essence a currency which offers a higher current interest rate, has a growing economy and the prospect of higher interest rates in the future should appreciate in value, compared to the currency of a stagnating economy, with low, or in this instance negative interest rates and the prospect of further easing in the future.However that theory has been turned on its head this year. The Yen has in fact strengthened against the US dollar in 2016 (these were the two currencies we described above) despite ongoing Quantitative Easing or QE in Japan, a perilous debt to gdp ratio and demographics which are frankly frightening.  For example the decline in Japan’s working age population.The chart below shows the working age population in Japan

The working age population in Japan, Source: Bloomberg/ @Schuldensuehner

The working age population in Japan, Source: Bloomberg/ @Schuldensuehner

Not only does Japan have to contend with a shrinking and ageing population. It also needs to address a downturn in productivity which peaked in early 2007. As we can see below. It also noticeable that the most recent dip in productivity has been accompanied by a strengthening Yen which of course makes Japanese exports dearer to foreign buyers. That relationship may help to explain the most recent dips in productivity but the longer term trend is harder to quantify.

Japan Productivity vs the Dollar Yen exchange rate (source: Trading Economics)

Japan Productivity vs the Dollar Yen exchange rate (source: Trading Economics)

Low ebb

Thursdays (31-03-16) Tankan survey data showed business sentiment in Japan is at its lowest ebb since the central bank embarked on its QE program in April 2013. That is no surprise when we consider charts such as the one below.  Which plots Japan’s Government Debt to GDP ratio and against the growth in GDP in Japan.

Japan Debt to GDP vs GDP Growth (source: Trading Economics)

Japan Debt to GDP vs GDP Growth (source: Trading Economics)

What we can clearly see above is that the debt to GDP ratio continues climb as GDP growth falls away. Japan is borrowing more and producing less, making the prospect of repaying its debts that much harder.

Hard to explain

At the start of the year it was easy enough to explain Yen strength as function of changes in hedge fund positioning and a flight to a liquid currency, in a period of volatile markets and risk aversion. Indeed we can see that relationship clearly mapped out below in a chart that plots the trade weighted Yen basket or Yen index, against the CBOE Volatility index or VIX, as it is commonly known. In early February both the VIX (a measure of fear among investors) and the Yen Index appreciated, in what was clearly a risk off period. However risk is very much back on the table now. As signified by the sharp drop in the VIX, which suffered its 5th largest ever percentage fall in Q1 2016. Yet at the same time the Yen index remains elevated.

Yen Index versus the CBOE VIX (Source: Investors Intelligence)

Yen Index versus the CBOE VIX (Source: Investors Intelligence)

Q1 also encompassed the move to negative interest rates in Japan, the markets buying into the idea that inflation is returning to the US economy and that therefore further US interest rate rises could be justified or warranted in 2016.By the same token however the Federal Reserve has performed its own about face in seeking to distance itself from the rising rates mantra, that it espoused prior to its March FOMC meeting.

Markets make prices

Nonetheless its markets that make prices and therefore for the reasons we have outlined above, we would have expected the Yen to weaken and US dollar to strengthen.However the exact opposite has been the case. It’s not obvious what catalyst if any, including an early rate rise in the US, would change this counter intuitive price action or trend.We are unsure exactly what’s going on here and so it would seem is the BOJ, judging by this recent soundbite from Governor Kuroda. “The BOJ’s board does not have official definition for deflation or escape from deflation”Japan is one step away from breaking the last monetary policy taboo that is monetization. I.E. printing cash to pay down debt, effectively debasing the currency. Some, including myself, would be tempted to argue that given the fact that the BOJ is now biggest holder and principal buyer of Japanese government bonds this is effectively happening already, on an unofficial basis and yet even this is not enough to derail the Yen.From a personal standpoint I believe that Japan is in danger of slipping into an economic black hole and as with these astronomical dead zones, once it slips over the event horizon there will be no way back. The combination of falling gdp, negative interest rates, mountainous debt levels and an appreciating currency are driving the economy ever closer to oblivion. In fact physicists theorise that an observer outside of black hole would not necessarily know that a body had entered that black hole. Because they would see the bodies image imprinted on the event horizon forever. Makes you think doesn’t it.

This is a guest post written by Darren Sinden, an analyst at Admiral Markets