Yen Weakness, Why It Matters, and Recession Risks

We cover the latest developments around the Japanese Yen, and dissect its implication for Asia and the rest of the World.

Yen Weakness, Why It Matters, and Recession Risks


Multi-Decade Trend Breaker

The Japanese Yen has been breaking through a significant number of major, and often multi-decade trends over the last few months.

The breakout initially began last year when USDJPY pushed through the 50-year downtrend (a rising line represents Yen weakness versus the US dollar).

The move accelerated in March with the break of a 30-year downtrend and continued in April with a record-breaking streak of 13 consecutive days of dollar strength versus the Yen as domestic investors repositioned for the start of the new financial year (in Japan, the financial year ends on March 31st).

The catalyst behind the move was the Bank of Japan’s recommitment to Yield Curve Control (reminder – Yield Curve Control (YCC) is a Central Banks attempt at keeping its yield curve, well, controlled, by artificially suppressing rates. It’s also necessary for heavily indebted countries, which Japan is, so that they can refinance that debt at lower yields).

Yields on the 10-year government bond are to be maintained in a 0.25% range on either side of zero. For now, that means they are capped at +0.25%.

So why is the BoJ making the choice for a weaker currency over higher yields, especially given the backdrop of what is happening everywhere else in the world? It’s tied to the historical issues of debt and demographics.

Therefore, given the choice between higher financing costs for these huge levels of debt (i.e. allowing rates to rise along with the rest of the world which could cause a government default and corporate bankruptcy), or higher inflation (which is still low compared to the rest of the developed world), policymakers prefer risking higher levels of inflation, which is having a material impact on the Yen.

So, Yield Curve Control it is.

How Long Can This Last For?

Extreme policy conditions can last for an extended period. For instance, expectations that Japan’s expanding debt levels would lead to a collapse in bond prices (and a default on its obligations) have swirled around the Japanese market for over 20 years. Most attempts to short JGBs (Japanese Government Bonds) have ended in failure, with the trade dubbed ‘the widow-maker’.

For as long as there will be policy support (YCC), it’s hard to make a compelling case for a market collapse. However, when policymakers do decide to withdraw support for extreme policy, the resulting price action can be dramatic. This is what happened when the Swiss National Bank stepped back from its intervention in the EURCHF (Euro vs Swiss Franc) market in 2015.

There are two major risks to letting inflation run higher (instead of allowing yields to reset at a higher level, similar to the rest of the world):

Competitive devaluations can lead to economic instability.

Fortunately, the position today is vastly different from the position in the 1990s. Dollar-denominated debts have been pared back and these economies are now much stronger. But, if weakness in the Yen encourages China’s policymakers to devalue the Yuan, then there will be negative repercussions for many of the region’s exporters. Whilst the levels of dollar-denominated government debt have fallen, many corporate dollar debt burdens remain extremely high.

In summary:

A general rule of thumb: markets can deal with slow change, but they struggle to deal with sudden and unpredictable moves.

The Bank of Japan has added an extra one, or maybe two layers of uncertainty to global markets.

Recession Risk is Rising

In last month’s note, we highlighted that recession risks were rising, despite many indicators (such as the level of the ISM Manufacturing Survey) suggesting that a recession should still be a couple of years away.

We shouldn’t, however, get carried away.

But as we argued last time, high levels of inflation can put a completely different complexion on data relationships. Economic outcomes can rapidly unravel, and consumer tailwinds can quickly turn into headwinds. Meaning, higher inflation = less consumption = lower GDP.

Consider this:

Besides consumer surveys, we also know that the current levels of inflation are unlike anything we’ve seen for 30 years. Although the ISM Manufacturing Index is in expansion territory, it could deteriorate rapidly.

Growth is thus starting to falter, but inflation remains at high levels. Peaks in inflation have coincided with recessions on almost every occasion since 1965.

The Fed has two choices:

Capping inflation whilst simultaneously achieving a soft landing is possible, but not probable. For now, the Fed rhetoric is clearly skewed towards capping inflation as the priority.

The difficulty for investors is gauging how much economic growth the Fed will need to sacrifice to control inflation before they can then reverse course back toward supporting growth without driving inflation much higher (many investors expect the old supportive Fed to return – case in point has been the dip buying mentality that has continued in many tech names despite their ongoing declines).

An early reversal in policy, however, could stoke another leg in inflation, accentuating the conditions that were already causing the slowdown prior to the first hike.

All in all, it may be better to generate a recession now, so that a recovery process can swiftly follow.

This would mean that:

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Natural Pools. | Watamu, Kenya
Published in: Markets
Roger Hirst

Leads all Macro research and content. Previously equity derivatives hedge fund sales and Delta-1 basket flow trading.

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