Mixed Signals

We are a little more than one month in to 2009. Since the New Year, some things have changed: the United States has a new president, a new Congress has been sworn in and we have a new economic team at the helm attempting to guide us in to safe harbor. Even the Arizona Cardinals surprised the oddsmakers and earned the right to play in one of the most memorable Super Bowls in recent history. However, many things remain the same. Dismal economic news continues to pour in from around the globe. The United States just announced that its fourth quarter gross domestic production (GDP) fell 3.8 percent annualized, the largest GDP contraction since 1982. The United Kingdom announced their economy shrank the most since 1980. Europe's manufacturing and service industries reportedly contracted in January for the eighth consecutive month. While Japan's industrial production fell 9.6 percent month to month to an all-time record low. In addition, December's Tankan Manufacturer's Index fell to -24 from -3 in September, the steepest quarterly drop since 1975. Russia continues to devalue its currency as investors line up to remove capital from the country. Even China has halted the yuan appreciation in an attempt to keep its exports flowing.

The foreign exchange market is also being driven by this alarming economic news. When fear and capital preservation are the overriding theme, risk aversion drives currencies in what seems irrational directions. Historically, the Japanese yen (JPY), Swiss franc (CHF) and U.S. dollar (USD) have been considered to have safe haven currency characteristics. In other words, these three currencies tend to appreciate when the global economy is weak and/or the global equity markets are underperforming. However, this time the CHF has been, and will likely continue to be, undermined by concerns about Swiss banks' exposure to emerging markets, especially in Eastern Europe. The U.S. dollar has been a big beneficiary even as the U.S. economy continues to fall deeper into a recession. The concern for safety is so high that investors have been willing to take negative yields just to park their money with "safe" government paper. The dollar's rally in the second half of 2008 has been largely driven by risk aversion, deleveraging and repatriation. In other words, despite the next to nothing yield offered by dollar-denominated investments, a flight safety into U.S. dollars and government bonds has kept the USD strong.

The Yen "Barometer"
The Japanese yen is following the same path. It has become an important barometer of investors' appetite for risk. If investors get worried, the yen often strengthens. Conversely, when investors are willing to go out on a limb, the yen tends to weaken. In the past, risk-taking investors were enticed to borrow cheap yen, then invest the borrowed money in other countries where returns can be higher (often called the carry trade). Historically, this weakens the yen because the borrowers are essentially selling yen to buy other currencies, which in turn strengthen. Nowadays, the JPY is one of the only currencies in higher demand than the dollar. Recently, the yen advanced to near 87 against the dollar, the strongest level since 1995. The JPY rose almost 12 percent versus the EUR in January alone and is nearly 45 percent higher against the British pound since July, 2008 (see chart). This strength is despite recent data confirming that Japan's slowdown has actually accelerated as in the rest of Asia. The Bank of Japan's recent monthly economic report downgraded its overall economic assessment, noting that "Japan's economy has been deteriorating and conditions are likely to become more severe in the immediate future." It said that production was falling sharply and was likely to continue to do so, indicating a glum picture for exports with demand is expected to decline sharply on the further slowdown in overseas economies and the stronger yen. On December 19, Bank of Japan trimmed its overnight policy rate by .20 percent to a mere 0.1 percent, its lowest bank borrowing rate since 2006.It indicated that it was buying Japanese government bonds outright and would temporarily buy commercial paper as a means improving liquidity.

Source: Bloomberg, SVB Financial Group

Repatriation Trend
In addition, there remains strong repatriation demand for the JPY. As the Asian emerging markets dive, Japanese investors are bound to move more capital back home, keeping yen demand intact. It is estimated that only about one half of available overseas funds have been repatriated back to Japan. The potential for more funds remitted back is high, due to Japan's huge offshore investment position, which is estimated to be over $2.5 trillion. Further pressure on the EUR and GBP and soft global equity markets will likely force Japanese institutions to bring more capital home.

The Squeeze
A strong JPY has placed an extra burden on the already weakening Japanese economy. Corporate profits have been squeezed from a slowing domestic economy on one side, while on the other side a worldwide recession and a very strong currency should make things even more painful for Japan's export-driven economy. There are forecasts Japanese automakers will continue to slash output, jobs and profits as the global recession deters consumers from buying automobiles. Toyota Motor Corp., Japan's biggest automaker, last month predicted its first operating loss in 71 years for this fiscal year because of low demand and a stronger yen. Honda announced it will cut profit forecast by 57 percent. Sony will begin eliminating 16,000 jobs as demand for televisions and digital cameras fall. Panasonic is projecting profits in the year ending this March 31 to be 90 percent lower than expected.Of course, such news is prompting speculation over what level of the yen will force the Bank of Japan authorities to intervene in the currency markets to halt further appreciation. Japanese economic officials have not ruled out action to curb the yen. Vice Finance Minister Shinohara was reported to say "We are closely monitoring the movements in the currency market." However, JPY strengthening has been relatively orderly without the wild price swings experienced in the USD against the EUR, GBP, and CAD. As long as an orderly trading continues, it will be difficult for the Bank of Japan to prevent the USD/JPY from gradually grinding towards 85. This leads me to believe the JPY will remain well supported for as long as the global economy remains weak and there remains a bearish sentiment for risky assets.