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Robin has been bullish on the Bank of Japan, but other opinions are available.
George Saravelos, for one. In a note published today, Deutsche Bank’s global head of forex research has turned both barrels on the yen. Here’s some popcorn 🍿, dive in:
Japanese intervention to defend the yen will at best be ineffective and at worst make the situation worse. Why? Because a simple glance of the yen’s drivers – yields and external accounts – puts the Japanese yen in the same league as the Turkish lira and Argentian peso [chart below]. Not only does Japan have the lowest nominal yield in the world (and the only economy with negative rates), but also record low real yields, a direct function of the BoJ’s refusal to tighten policy in the face of high inflation. Japan now also has one of the worst broad basic balances in the world – not on the back of a large current account deficit but because the BoJ has effectively engineered slow-motion capital flight from domestic investors into foreign assets. If you are Japanese, what is the point of buying a 5-year JGB with a nominal yield of 50bps when you can buy a 5-year US treasury with a real yield of 3%?
The promised chart:
Saravelos, cont.:
The “solution” to therefore stabilize the yen is simple: the Bank of Japan needs to stop QE and start hiking rates. On the flipside, FX intervention is likely to achieve the opposite: by selling dollar reserves (treasuries) it will likely put further upward pressure on US yields and support the dollar. More critically it will lead to a deterioration of the Japanese government’s external balance sheet and by extension its fiscal position. This, together with the fresh fiscal spending that is being announced is the opposite of what should be happening in an environment where the cost of government funding is starting to rise.
The UK crisis last year showed how markets can react abruptly to policy that is perceived to be off-kilter. In Japan’s case however, these non-linearities are unlikely to show up in the bond market. The BoJ owns the near-entirety of the stock of ten-year bonds and more than half of all JGBs. The price formation mechanism in fixed income is effectively suspended, inclusive of 5y5y inflation breakevens at less than 1%. Instead, the transmission mechanism of market pressure will have to happen solely via the exchange rate. The way this works is simple: accelerating capital outflow as real yields keep moving deeper into negative territory.
Krugman famously wrote that for Japan to move out of deflation, the central bank has to follow irresponsible policy: stay dovish even as inflation is rising. The central bank is most certainly living up to this promise. But as the policy setting becomes more and more extreme, the risks around non-linear moves in the market go up. At the moment, yen volatility remains very well contained and option market risk reversals suggest the next big move in USD/JPY will be down, not up. This is telling us that the market still believes that the BoJ will ultimately do the “right thing”: defend an inflation target at 2% and the yen’s nominal anchor. Yet being truly irresponsible implies that the market starts to question whether the BoJ is willing or able to defend the inflation target from above. PPP valuations then become less relevant and domestic investors start permanently abandoning the currency. Things then get really volatile.
At the end of the day, the last two years’ broad yen underperformance can only reverse when one simple thing happens: the Bank of Japan starts hiking rates, and far more than a tiny move to zero. When and if that happens, rather than FX intervention, is pretty much the only thing that matters.
Deutsche Bank hasn’t entered a team for the FTAV Pub Quiz on Thursday so we probably won’t get an opportunity to see this difference of opinion spill out onto the streets. If it does, whoever our money is on, it won’t be in yen.
Further reading
— The BoJ is playing a blinder
