The leading narrative in the foreign exchange markets is told and re-told to explain how the Japanese yen has surged this year despite an ever wilder monetary experiment pursued by the Abe government.

The story seems plausible to many, and thus is deeply challenging for the backers of sound money principles. The financial TV commentators tell us that the yen is now the safest of all the safe havens. How can this be so?

The False Narrative

The story we’re told is that the spectacular failure of the Abe Government to further depreciate the yen — by introducing a negative interest rate regime in mid-February — has revealed that the Great Monetary Experiment, more extreme in Japan than anywhere else in the world, has reached the end of the road.

Alongside of this, the Fed watchers tell us that Chief Yellen has become fearful of monetary policy paralysis in the next economic downturn (whenever that is) given that Japan has now demonstrated that non-conventional policy options for escaping the zero rate boundary are dubious. She and her colleagues have been pontificating of late about the need for monetary policy to acknowledge asymmetry – taking more care to avoid precipitating an economic downturn (against which policy response might be ineffective) than avoiding an upturn of inflation above the sacrosanct target of perpetual inflation at 2% per annum (against which policy response should still be effective).

These tales have helped to drive the yen up and the dollar down. And in the global market-place there is the well-documented Pavlovian reaction whereby when Tokyo equities plunge — for whatever reason — the yen jumps. Japanese investor appetite for foreign assets (unhedged) shrinks when a main component of wealth (Tokyo stocks) is swooning. That is what happened when the negative interest rate announcement triggered an instant steep decline in Tokyo banking stocks as concerns immediately emerged about the hit to profits across that industry where so much of reported earnings stem from essentially “playing the yield curve” (borrowing at short term rates and lending at long-term rates). Negative rates brought an instant tumble in long-term rates while banks have desisted from charging negative rates on customer deposits. The boom in safe-box sales illustrates that the public is readying to hoard banknotes rather than suffer that iniquity.

The Investor Response to the False Narrative

For most of the time the Japanese and US stock markets are moving together under common risk-off or risk-on trends. But in late winter and early spring this year there has been divergence. The plunge in the Tokyo market has been the big episode this year in the “progress” of the global asset price inflation disease (with its original source in the Fed’s Great Monetary Experiment) towards its late dangerous phase. In mid- and late-mid phases of the disease, it is typical to observe speculative temperatures high and even rising in some asset classes whilst tumbling in others. Hence, we have seen the Tokyo equity market decline as the speculative story of Abe economics triggering Japanese economic renaissance implode. And, yet other risk asset markets have been re-bounding from their New Year swoon under the influence of the Yellen Fed backtracking from its “rate lift off strategy.”

The dynamic path to the yen surge this year has included not just Pavlovian reaction but much trader-type narrative, which is always important in understanding the precise impact of market shock.

Undoubtedly the falling yen of the past three years had attracted much speculative trend-following. The people behind those trades did not necessarily understand how PM Abe and his central bank chief were going to achieve perpetual yen depreciation defying all historical precedent according to which at some point the US would take exception. The trend followers included large international investors in Tokyo equities who decided to go for the Royal Flush — combing long positions in Japanese stocks with short positions in the currency. When the trend stopped abruptly in the wake of the negative interest rate shock many decided to unwind the currency shorts (while retaining the stocks). And Japanese institutional investors holding huge portfolios of foreign currency bonds decided to protect their yen profits by upping their hedge ratios. This was particularly visible in the highly popular short yen long pound carry trade, where the risk of Brexit became an added trigger to action.

A Critical Look at the Official Story

The story told fits the facts of the market drama this year to date. But there are untruths which should cause us to reject it as a reliable narrative for predicting future market developments or for making fundamental economic assertions. In particular, the Japanese monetary experiment has not reached the end of the road. It is still alive and has great potential to do much damage. Massive monetary base expansion and long-term interest rate manipulation (10-year government bond yields at zero or below) – with the Bank of Japan effectively printing money to fund the entire government deficit (6-7% of GDP) and more — are crippling and distorting the invisible hand. Yes, measured goods and services inflation is still barely positive, but that is largely a reflection of the extent to which monetary and exchange rate uncertainty has frightened Japanese business from investing and to which households, especially elderly, have responded to earlier currency depreciation and the resulting squeeze on their real incomes by spending less. Hence, economic growth has been sluggish (taking due account of declining population of working age).

The Likely Next Steps for Japan

Wild monetary experimentation in Japan will most likely intensify even though the authorities may well be more cautious in applying further the negative rate tool meanwhile. More likely they will simply accelerate the pace of monetary base expansion. And every indication suggests that the Abe government is turning to increased fiscal “reflation” – already front-loading spending into the first half of this fiscal year and widely anticipated to abandon the planned sales tax hike programmed for early 2017. The military budget is set to increase sharply now that the Diet has adopted the change in interpretation of the Constitution away from pacifism. Rapid ageing of the population in principle adds to upward pressure on the neutral level of interest rates (alongside budget deficit explosion) and an emerging gap of this above market rates would translate into an inflationary process.

A sudden yen reversal (weakening) should come as no surprise and could ignite inflationary expectations. The key here would be Japanese investors deciding in light of the rotten performance of their own equity market and the alarming state of the national public finances to embark on a much bolder and well thought out journey of international diversification. That would be a much more resilient source of yen weakness than periodic bursts of foreign speculation on a weak yen trend underpinned by unsustainable excitement about PM Abe and BoJ Chief Kuroda’s new bag of tools whilst the key ingredient of domestic capital flight remains missing.


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