How Much Yen Pain Can Japan Bear?

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The question of how much Yen pain can Japan bear is a question of how low the Japanese government will allow USD/JPY to go. Since the middle of March, USD/JPY has fallen as much as 7 percent. While significant milestones were not reached, USD/JPY is trading not far from its record low. A strong currency is one of the worst things possible for an export dependent country like Japan. In fact, a strong Yen contributed to the dramatic deterioration in Japan’s trade balances. For the first time in more than 30 years, Japan turned a trade deficit in 2011. While this was largely caused by the March 2011 earthquake and nuclear disaster, the country continues to run a monthly trade deficit because of demand for fossil fuel – which is not normal for a country like Japan. Exporters are screaming for help but all the Japanese government has said is that they are watching the currency closely.

This leads many investors to wonder how the Japanese government can stand on the sidelines and watch idly as the Yen continues to threaten the health of the economy?

Their reasons are the following:

#1 Japan Is Not Doing That Bad

The population is aging and the savings rate is declining but the Japanese economy is not doing that poorly. Japanese firms have learned to cope with a strong Yen and are use to hedging their foreign exchange exposures. The country is also gradually recovering from last year’s earthquake with increased government spending and rising consumer consumption expected to help the economy grow at a faster pace this year. In fact earlier this month, the Cabinet Office upgraded its growth figures and confirmed that the Japanese economy expanded for the past 3 quarters. This is not to say that we are optimistic on the outlook for Japan’s economy – quite the contrary – we believe that Japan will suffer from the double blow of a strong currency and weak global demand but for the time being the economy is not doing as poorly as many fear and positioning is not extreme enough to prompt intervention.

#2 Why Do Anything if its Out of their Hands

More importantly however, the Japanese believe that they have no control over Yen strength and they are right. All of Europe’s problems have led investors to seek refuge in the Yen and even if the Bank of Japan were to intervene, the effects would be short-lived if investors remain nervous and the markets continue to weaken. There is no question that the Yen is overvalued and right now, the Ministry of Finance believes that it would be waste of capital to fight against broader market forces. Instead they opted to increase asset purchases in February and April with the goal of keeping interest rates low and pumping more money into the Japanese economy.

#3 Intervention Rarely Works, So Why Try?

At the same time, the Ministry of Finance and the Bank of Japan knows very well that intervention rarely works. The last 2 times that the BoJ intervened to weaken the Yen was in late October, early November and in August of 2011 and on both occasions, the Yen recovered its gains in the days that followed. As show in the charts below, the BoJ has almost never intervened successfully but political and market pressure do not stop them from trying.

BoJ’s Line in the Sand

With the 78 level in USD/JPY broken and tested at the end of May, the line in the sand for the Bank of Japan should be between 76.50 and 77. On November 1, they came in after USD/JPY dropped to a low of 75.57, in August they came in around 77 and in March 2011 they bought USD/JPY after it fell below 76.50. USD/JPY has never fallen below 75.57, which tells us that this should be the ultimate point of pain that the Japanese government will be willing to bear but we believe they will come into the market sooner than that.

Yet BoJ May Have No Choice if Fed Eases

One possible trigger for USD/JPY intervention is another round of Quantitative Easing from the Federal Reserve, which is becoming an increasing possibility. The labor market deteriorated significantly in the past 2 months while inflationary pressures have eased. With global demand expected to weaken further, it should only be a matter of time before the Fed gives the U.S. economy another jolt of momentum by increasing their asset purchases program. Both the U.S. dollar and the Japanese Yen are safe haven currencies but more aggressive action from the Federal Reserve could lead to a renewed appetite to short USD/JPY.

Kathy Lien
Managing Director

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