The Japanese Yen Will Confound Forecasters Yet Again

"The only function of economic forecasting is to make astrology look respectable." - John Kenneth Galbraith

We have witnessed a series of tragic events in Japan over the past few weeks. It will take years for the physical scars to heal and much longer before the emotional damage fades from memory, if in fact it ever does. To add to its woes, Japan has been stuck in an economic malaise of historic proportions. Its stock market, the Nikkei, has fallen from a high of almost 39,000 in early 1990 to a closing level of 9755 on March 31, a decline of about 75 percent. Real estate prices are at about half their 1990 peak and many financial institutions remain barely functional. Many feared a similar fate for the U.S. economy following the financial crisis in 2008-2009, but fortunately they appear to be wrong; for now. The economy is recovering, albeit at a slow and uneven pace.

Japan's prospects don't look much better for the next few years either. China has replaced Japan as the second largest economy in the world, thanks largely to robust economic growth in China, while Japan languishes. In addition, Japan has an aging and shrinking population, a deficit to GDP ratio that has for years been the highest in the developed world (until we overtook them this year) and a dependence on oil and other commodities that are surging in price.

Despite these economic woes, the Japanese yen remains strong. Around the time the Nikkei approached 39,000 in 1990, the yen stood at 160 yen per dollar. For most of the last five or six months, is has been in an 80 to 85 range, except for a brief surge to 76.25 in the days following the earthquake and tsunami. There have been several reasons for yen strength since the financial crisis began. Here are a few:

• The yen and the Swiss franc, both low yielding currencies, tend to be safe havens in times of risk aversion, much like the U.S. dollar. Investors favor higher yielding emerging market and commodity currencies when optimism is high, but park money in the yen when they are nervous or uncertain about the economic outlook. Global risk aversion was the aftermath of the financial crisis and the yen benefited.
   
• Yen interest rates are amongst the lowest in the world and this has been true for most of the last two decades, as the Japanese government and central bank have tried in vain to stimulate economic growth. When global growth slows, like it did in 2008 and 2009, global rates fall as well and the yen's comparative yield disadvantage decreases, resulting in yen appreciation.
   
• Finally, when Japanese investors suffer a financial shock or face uncertainty, they have historically responded by liquidating foreign assets and repatriating funds to Japan, to shore up their balance sheets. This clearly happened over the past couple of years.
  
  As a result of the events of the past couple of years, forecasters who were negative on Japan's economic prospects and on the yen have consistently been wrong; they projected yen weakness which never materialized. The table below shows data from Bloomberg, which polls banks around the world to get their currency forecasts. These are the median forecasts at various points in time over the past six months:

Source: Bloomberg, SVB Financial Group

What I find noteworthy is that, although the yen is virtually unchanged between the end of the third quarter of 2010 and March 31 this year, with the exception of the blip on March 17 consensus forecasts for both the end of 2011 and 2012 noticeably shifted in favor of less yen weakness. In other words, forecasters are not as convinced as they were about the prospects for material yen weakness in the months and years ahead.

In my opinion, they have thrown in the towel too early. I believe we are in the process of forming a base and assuming the 80 level holds, could see significant yen weakness over the next couple of years. I have summarized my main reasons below: 

• Repatriation fears are overdone: Financial institutions such as life and casualty insurance companies that face significant additional claims will likely fund them from claims on government-backed reinsurance companies, by dipping into retained earnings and by selling their holdings of Japanese Government Bonds (JGBs). By all accounts, only a minor portion will require the sale of foreign assets. Pension funds hold significant foreign assets, but unlike the insurance companies above, the recent tragedies will not impact redemptions. It is, in fact, possible that recent yen strength and the bounce off the recent lows in Japanese equities might actually make them underweight foreign assets, perhaps requiring a top up in those investments, or a sale of the yen. Commercial banks that face claims are likely to need to sell JGBs, not foreign assets. Like banks elsewhere in the world, they have become increasingly risk averse over the last two years and opted to hold most of their reserves in government paper or cash. Retail investors that face financial difficulties may well need to liquidate some of their foreign holdings. However, the percentage of those directly impacted is so low that it is unlikely to move the needle significantly in terms of market impact, unless there was sudden and coordinated liquidation, which has not occurred up to this point.
  
  Foreign buyers remain long on Japanese equities. They rushed in to find bargains after the earthquake and they have been rewarded by an almost twenty percent surge in the Nikkei. Unless equities continue to rally significantly, there is likely to be some profit taking, resulting in money flowing out.
   
• Quantitative easing: The Bank of Japan (BOJ) is committed to maintaining ample liquidity and keeping rates low, to support the economy in both the short and medium term. Any selling pressure in the JGB market — from banks or others — will almost certainly be met by fresh buying from the BOJ. This virtually unlimited amount of quantitative easing might boost stocks, but will keep rates low and weaken the yen.
   
• A global recovery should mean a weaker yen: As the U.S., Europe and other parts of the world continue to recover, inflation will rise and so will interest rates. The U.S. employment report last Friday was robust and should add to hopes of a sustainable recovery here. On the other hand, the BOJ will be forced to keep rates low and maintain an accommodative monetary policy, which will hurt the yen. In addition, domestic investors are likely to find more compelling investment opportunities outside Japan as long as the domestic economy struggles, leading to more capital outflows, which will pressure the yen.

As Japan struggles to emerge from this tragedy, fight a twenty year pattern of subpar growth and overcome its longer-term secular challenges, easy money and a weak yen are what the economy needs and what policy makers want. The government's hands are tied on the fiscal front, given its somewhat precarious deficit situation and the constant threat of ratings downgrades, leaving easier monetary policy and a weak yen as their main weapons to boost economic growth and exports.

In my opinion, too great a focus on repatriation flows has clouded the picture. It is in Japan's interest for the yen to weaken and the international community appears supportive. If investment and speculative flows fall into alignment as well as I believe they will, the yen will break above the 85 level shortly, which will generate further selling pressure and a likely move towards 95 and then 100. A lot of technology companies with un-hedged yen receivables have benefited significantly from yen strength over the past few years. That might soon change.