The Yin and Yang is a fundamental concept of Chinese medicine. The Yin and Yang philosophy has four main aspects a) They are opposites b) They are interdependent c) They keep changing and d) One can change into another at points of time.
The Yin and Yang theory applies to the Japanese Yen and Global Financial markets. One is the Yin and the other is the Yang, though which is Yin and which is Yang is left to philosophy. The fact is that the movement of the Japanese Yen plays an important role in the way markets of equities, bonds and commodities behave globally.
The Yen at points of time becomes a safe haven currency while at other points of time becomes a carry trade currency. The sharp depreciation in the Yen against the USD and the Euro over the last couple of months suggest that the Yen is changing its status from a safe haven currency to a carry trade currency. The continuation of Yen depreciation will lead to rally in equities globally and in India. Indian bonds will gain in price while the Indian Rupee strengthens against the USD.
Why is the Yen turning out to be a carry trade currency in 2013?
The sharp fall in the Yen over the last couple of months has been due to two reasons a) Japan’s politics and b) Japan’s growth dynamics. Table 1 gives the performance of the Yen against the USD and the Euro since November 2012.
Japan has seen a change in the political leadership in December 2012. The current Prime Minister Shinzo Abe replaced Yoshihiko Noda the former prime minister after the former won the elections in December. Shinzo Abe has pledged to pull up the Japanese economy that has been reeling from weak exports due to a strong Yen. Japan’s exports fell by 9.5% in November 2012 on a year on year basis on the back of a strong Yen and weak global demand. Japan’s GDP growth has contracted in the second and third quarter of 2012.
Japan is getting a big dose of fiscal and monetary stimulus that is expected to revive the economy. The new Prime Minister has unveiled a USD 116 billion fiscal stimulus for the economy. The Bank of Japan expanded its asset purchase program by USD 117 billion in December 2012 to take the total asset purchase program size to USD 1 trillion. The Prime Minister is keen on the Bank of Japan setting itself an inflation target of 2% from deflationary levels in order to pump in money into the system to push the economy on a growth path.
The offshoot of Japan’s stimulus measures and on the inflation target adopted by the Bank of Japan is a weak Yen. The Japanese Government is also buying bonds issued by the ESM (European Stability Mechanism) in order to improve the prospects for the Eurozone economy and in order to weaken the Yen against the Euro. Hence fiscal and monetary stimulus measures coupled with Euro bond purchases by Japan will keep the Yen under pressure.
Interest rates in Japan are the lowest in the World. Short maturity government bond yields are less than 0.2% while ten year bond yields are at 0.8%. The thirty year bond is trading at 1.98% and the 118bps spread between the ten year and thirty year bond reflects the inflation rate target of 2% (not yet adopted but expected to be adopted) by the Bank of Japan.
The weak Yen policies followed by Japan will encourage markets to use the Yen as a funding currency. Market players will borrow in Yen at low interest rates and buy assets of other countries where interest rates are higher. This “Yen Carry Trade” will drive equities, bond prices and currencies of countries where growth and interest rates are high on a relative basis.
The commodity market may not benefit much from Yen carry trades as the prospect of higher oil production in the US and the below trend growth in the Eurozone, China and India weakens demand for commodities.
The Yen and Yang of it all
The Yen’s relationship with financial markets is negatively correlated with a weak Yen taking up markets and vice versa. The Yen is an important currency in the global system as it is a free float currency and it is the third largest traded currency in the world behind the USD and the Euro. Yen levels depend on financial markets while financial market levels depend on Yen. The Yen changes its profile from safe haven currency to a carry trade currency. The Yen leads markets in certain times while the markets lead the Yen in other times.
