Chapter 30
Currency Profile: Japanese Yen (JPY)

Economic Overview

Japan is the third largest economy in the world with GDP valued at over US$4.6 trillion in 2014 (behind the United States and China). If we count the European Union as a whole, it would be considered the fourth largest economy. Japan is one of the world's largest exporters and is responsible for over US$690 billion in exports per year. Manufacturing and exports of products such as electronics and cars are the signature drivers of the economy, accounting for nearly 17% of GDP. As a result, Japanese growth is extremely sensitive to the value of the currency. For many years, Japan has maintained a trade surplus, but the earthquake followed by tsunami in 2011 turned the country into a net oil importer and created a long period of trade imbalances, where oil imports exceeded exports in value. This began to change in early 2015, when a weakening yen and falling oil prices helped to turn around trade activity, returning Japan to a surplus nation. Having a trade surplus means that there will be inherent demand for the Japanese yen even when interest rates are low and there are structural deficiencies. Japan's most important trade partners are the United States and China:

Leading Export Markets

1. China
2. United States
3. South Korea
4. Taiwan
5. Hong Kong

Leading Import Sources:

1. China
2. United States
3. South Korea
4. Australia
5. Saudi Arabia

Abenomics

In the 1980s, Japan's capital market was one of the most attractive markets for international investors seeking investment opportunities in Asia. Japan had the most developed capital markets in the region, and its banking system was considered to be the one of the strongest in the world. At the time, the country was experiencing above-trend economic growth and near zero inflation. This resulted in rapid growth expectations, boosted asset prices, and rapid credit expansion, leading to the development of an asset bubble. Between 1990 and 1997, the asset bubble collapsed, inducing a US$10 trillion decline in asset prices, with the fall in real estate values accounting for nearly 65% of the total decline, nearly two years of national output. This fall in asset prices sparked the banking crisis in Japan. It began in the early 1990s and developed into a full-blown systemic crisis in 1997 following the failure of a number of high-profile financial institutions. Many of these banks and financial institutions extended loans to builders and real estate developers at the height of the asset bubble in the 1980s, with land as collateral. A number of these developers defaulted after the asset bubble collapse, leaving the country's banks saddled with bad debt and collateral worth sometimes 60% to 80% less than when the loans were taken out. Due to the large size of these banking institutions and their role in corporate funding, the crisis had profound effects on Japan and the global economy. Enormous bad debts, falling stock prices, and a collapsing real estate sector crippled Japan's economy for more than two decades.

It was not until the rollout of Abenomics that the economy began to turn around. When Shinzo Abe became prime minister for the second time in 2012, he rolled out a three-pronged plan to stimulate growth and pull the economy out of stagnation through monetary policy, fiscal policy, and economic growth strategies. This was known as Abenomics. In the first few weeks of the program, Abe announced a massive stimulus package that involved significant government spending and a strong dose of quantitative easing. The effects were almost immediate, with the Japanese yen falling significantly across the board. Not soon after, the unemployment rate started to fall and growth slowly returned.

Monetary and Fiscal Policy Makers

Monetary policy in Japan is determined by the Bank of Japan (BoJ). In 1998, the Japanese government passed laws giving the BoJ operational independence from the Ministry of Finance (MoF) and complete control over monetary policy. However, despite the government's attempts to decentralize decision making, the MoF still remains in charge of foreign exchange policy. The BoJ is responsible for executing all official Japanese foreign exchange transactions at the direction of the MoF. The Bank of Japan's Policy Board consists of the BoJ governor, two deputy governors, and six other members. Monetary policy meetings are held twice a month, with briefings and press releases provided immediately. The BoJ also publishes a Monthly Report issued by the Policy Board, and a Monthly Economic Report. These reports are important to watch for changes in BoJ sentiment and signals of new monetary or fiscal policy measures, as the government is constantly trying to develop fresh initiatives to stimulate growth.

The MoF and the BoJ are very important institutions, and they both can influence currency movements. Since the MoF is the director of foreign exchange interventions, it is important to watch and keep abreast of the comments made from MoF officials. Being an export driven economy, the government tends to favor a weaker currency. So if the Japanese yen appreciates significantly or too rapidly against the dollar, members of the BoJ and MoF will become increasingly vocal about their concerns or disapproval in regards to its current level or recent movements. These comments can affect how the yen moves, but if government officials flood the market with comments and there is no follow-up action, the market would start to become immune to these concerns. However, the MoF and BoJ have a lengthy history of interventions in the currency markets to manipulate the value of the yen value in Japan's best interests, so their comments cannot be completely ignored.

The most popular tool that the BoJ uses to control monetary policy is open market operations.

Open Market Operations

These activities are focused on controlling the uncollateralized overnight call rate. The Bank of Japan has maintained a zero interest rate policy (ZIRP) for some time now, which means that the Bank of Japan cannot lower this rate further to stimulate growth, consumption, or liquidity. Therefore, in order to maintain zero interest rates, the BoJ has to manipulate liquidity through open market operations, targeting zero interest on the overnight call rate. It manipulates liquidity by the outright buying or selling of bills, repos, or Japanese government bonds. A repo transaction involves a cash taker (borrower) selling securities to a cash provider (lender), while agreeing to repurchase the securities of the same type and quantity at a later date. This structure is similar to a secured loan, whereby the cash taker must pay the cash provider interest. These repo transactions tend to have very short maturities, ranging from one day to a few weeks.

Important Characteristics of the JPY

• Proxy for Asian strength/weakness. Japan tends to be seen as a proxy for broad Asian strength because the country has the largest GDP in Asia outside of China. With the most developed capital markets, Japan was once the primary destination for all investors who wanted access into the region. Japan also conducts a significant amount of trade with its Asian partners. As a result, economic problems or political instability in Japan tend to spill over into the other Asian countries. However, this spillover is not one-sided. Economic or political problems in other Asian economies, particularly China, can also have dramatic impacts on the Japanese economy and in turn movements in the Japanese yen. For example, North Korean political instability poses a great risk to Japan and the Japanese yen due to the country's geographic proximity.
• Bank of Japan intervention practices. The BoJ and MoF are active participants in the foreign exchange markets. That is, they have a lengthy history of entering the FX markets if they are dissatisfied with the value of the Japanese yen. While they have not intervened since 2011, they won't be reluctant to do so if the currency strengthens significantly. As Japan is a very political economy, with close ties between government officials and principals of large private institutions, the MoF can have a very narrow segment in mind when it decides to intervene in the currency. Since the BoJ is such an active participant, it is very in tune with the market movements and its participants. Periodically, the BoJ receives information on large hedge fund positions from banks and likes to intervene when speculators are on the other side of the market, allowing them to get the most “bang for the bucks.” The MoF and BoJ always considers three main factors before intervention:
  1. Amount of appreciation/depreciation in JPY—Intervention has historically occurred when the yen moves by 7 or more yen in less than 6 weeks. Using the USDJPY as a barometer, 7 yen would be equivalent to 700 pips, which would represent a move from 120.00 to 127.00.
  2. Current USDJPY rate—Historically, only 11% of all BoJ interventions that were conducted to counter a strong JPY occurred above the 115 level.
  3. Speculative positions—In order to maximize the impact of intervention, the BoJ and MoF prefer to intervene when market participants hold massive positions in the opposing direction because the flow of stops will exacerbate the reversal in the currency pair. The CFTC provides a weekly report on existing speculative positions that can be found at www.cftc.gov.

• JPY movements are sensitive to time. The Japanese yen can be particularly active towards the end of Japan's fiscal year (March 31), as exporters repatriate their dollar denominated assets to window dress their balance sheets. This is particularly important for Japanese banks because they need to rebuild their balance sheets to meet FSA guidelines that require the banks to mark to market their security holdings. In anticipation of the need for repatriation-related purchases, Japanese yen speculators frequently bid the yen higher in attempt to take advantage of this increased inflow. As a result, following fiscal year end, the Japanese yen tends to have a bias toward depreciation as speculators close their positions.

  Aside from the fiscal year end, time is also a factor on a day-to-day basis. Unlike traders in London or New York who typically have lunch at their trading desk, Japanese traders tend to take hour-long lunches, leaving only a junior trader in the office. On occasion, this can translate into additional volatility in the yen during this period as the market becomes illiquid. In addition to this period, the JPY tends to move fairly orderly during Japanese and London hours, unless there are official comments or major surprises in economic data. During U.S. hours, however, the JPY tends to have higher volatility, as U.S. traders are actively engaging in dollar and yen positions.

  

  Figure 30.1 USDJPY 10-Year Chart

  Source: eSignal

• Stocks and bonds have a positive correlation with USDJPY. The Nikkei has a positive correlation with USDJPY, which means that when the currency pair appreciating, equities are generally on the rise as well. For Japan, the currency typically leads equities because a weak yen is positive for the economy, but there can be times when equities lead currencies. The spread between U.S. 10-year Treasury and JGB yields is also very important for the currency. Typically, when the yield spread is on the rise, we see USDJPY move higher, and when the yield spread declines, it creates pressure on USDJPY. Figure 30.1 highlights the 10 year performance of USDJPY.
• Carry trade effects. The popularity of carry trades has increased in recent years, as investors are actively seeking high-yielding assets. With the Japanese yen having the lowest interest rate of all industrialized countries, it is the primary currency sold or borrowed in carry trades. The most popular carry trade currencies included GBPJPY, AUDJPY, NZDJPY, and even USDJPY. Carry traders would go short the Japanese yen against the higher yielding currencies. Unwinding of carry trades as result of spread narrowing is typically beneficial for the Japanese yen, as the reversal process involves purchasing the yen and buying back other currencies. Since there is so much demand to sell the yen for carry, in periods of risk aversion, these trades can be unwound quickly creating a significant rally in the currency.

Important Economic Indicators for Japan

Since Japan is a manufacturing-oriented economy, manufacturing data tend to have the most significant impact on the yen. However, on a monthly basis, unless there is a big surprise, Japanese data do not typically move the currency. The most influential event risk is always the monetary policy announcement and trade balance. Aside from that, these are the numbers to watch.

Tankan Survey

If there is one piece of Japanese data to follow, it should be the quarterly Tankan Report. The Tankan is an economic survey of Japanese enterprises published four times a year. The survey includes more than 9,000 enterprises, which are divided into four major groups: large, small, and medium-sized companies, as well as principal enterprises. The survey provides us with an overall impression of the business climate in Japan and is widely watched and anticipated by foreign exchange market participants.

Balance of Payments

The monthly balance of payments report provides investors with insight into Japan's international economic transactions that include goods, services, investment income, and capital flows. The current account side of BoJ can be used a good gauge of international trade. Figures are released on a monthly and semiannual basis.

Employment

Employment figures are reported on a monthly basis by the Management and Coordination Agency of Japan. The employment release measures the number of jobs and unemployment rate for the country as a whole. The data are obtained through a statistical survey of the current labor force. This release is a closely watched economic indicator because of its timeliness and its importance as a leading indicator of economic activity.

Industrial Production

The industrial production (IP) index measures trends in the output of Japanese manufacturing, mining, and utilities companies. Output refers to the total quantity of items produced. The index covers the production of goods for domestic sales in Japan and for export. It excludes production in the agriculture, construction, transportation, communication, trade, finance, and service industries; government output; and imports. The IP index is then developed by weighting each component according to its relative importance during this base period. Investors feel IP and inventory accumulation have strong correlations with total output and can provide valuable insight into the current state of the economy.

GDP

Gross domestic product (GDP) is a broad measure of the total production and consumption of goods and services measured over quarterly and yearly periods in Japan. GDP is measured by adding total expenditures by households, businesses, government, and net foreign purchases. The GDP price deflator is used to convert output measured at current prices into constant-dollar GDP. Preliminary reports are the most significant for FX market participants.