Canary in a Coal Mine

"To paraphrase Winston Churchill's famous statement about democracy, the floating exchange rate system is the worst possible system, except for all others."

-Robert Rubin, former U.S. Treasury Secretary

This past week, the currency markets have found no shelter from the storm that seems to part of the financial markets' daily routine. The dollar continues to climb higher as weak economic news pours in from around the globe. Last week, the United Kingdom reported that retail sales fell again. The Bank of England is signaling further interest rate cuts are likely on top of those recently announced. The European economies are tanking as reflected by Europe's recent gross domestic product numbers, confirming a recession is in full swing.

The exception to the strong dollar (USD) is its value against the Japanese yen (JPY). The JPY has actually strengthened nearly 15 percent against the USD since August and nearly 30 percent against the EUR for the same time period. This strength is despite disappointing Japanese GDP figures for Q3. Japan's economy, the second largest in the world, fell into an official recession for the first time since 2001 as GDP fell an annualized 0.4 percent in Q3. In addition, the Bank of Japan policy board cut its target overnight call rate by 20 bps to 0.30 percent at its October 31 meeting, the first rate cut in seven years.

One of the basic tools to judge a currency's outlook is to review the economy's strength and relative interest rate environment when compared to another currency. So why is the JPY so strong despite its poor economic performance and near zero interest rates, which are well below other major currencies? Is the Japanese economy so much better than the European economies that it should be 30 percent stronger against the EUR in just four months? Despite all the poor news in the U.S., is the yen really justified in appreciating nearly 15 percent since August?

The answer to these questions is not so simple. When fear and capital preservation are the overriding theme, risk aversion often drives currencies in what seem irrational directions. Recently, the yen has become an unexpectedly important barometer of investors' appetite for risk worldwide. 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, and 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.

One of the key tools to gauge the value of the Japanese yen has been the performance of the U.S. stock market, and the correlation between the Dow, the S&P and the yen. As U.S. stock indices and the value of my 401(k) get hammered, it proves disastrous for the broader risk sentiment, and a flight to safety is producing sharp Japanese yen and U.S. dollar strength. For the last several months, investors clearly reduced their exposure to risk over a broad range of assets, driving down investments from stocks to commodities, and buying safe-haven assets such as U.S. Treasuries. Late last week, U.S. T-bill yields are near zero, while the longer dates bonds saw yields plummet on demand for the safety of U.S. government debt.


The Road Ahead
The next several trading weeks of the U.S. Dow Jones could prove critical for both the global equity markets and foreign exchange markets. There is a clear indication of risk aversion in the markets that should continue to work in favor of Japanese yen strength. As the global economy slips into a deeper recession, the USD and JPY will continue to rise against every other currency around the globe. In addition, there is still strong repatriation demand for yen. As the Asian emerging markets slip, Japanese investors will be bound to move capital back home, keeping the yen rally intact. It is estimated that only one half of available funds have been repatriated. The potential for more funds remitted back to Japan is great, due to Japan's huge offshore investments.

The only glimmer of hope for the JPY to reverse this trend is good old government involvement. Finance Minister Nagakawa and Japan's Ambassador to the U.S. Fujisaki recently said the dollar should remain the world's reserve currency suggesting that Japanese officials remain concerned over the weak level of the USD-JPY. Japanese exporters, from Toyota to Canon, are announcing profit warnings as sales forecasts would fall on a global economic slowdown and an overvalued currency. Any intervention may be offer temporary support. However, we all know what government intervention can present. In my opinion, 85 yen to the USD is possible by mid-2009.