Corporate Finance : Foreign Exchange
Fed Tightening Strangles Yen


By all rights, these should have been the glory days for the Japanese yen. The Nikkei average is trading at the highest levels in four years as foreign money flows into Japanese stocks. The economy is showing sustained growth, and Japanese monetary authorities are on the verge of declaring victory over deflation. Meanwhile, Prime Minister Junichiro Koizumi has won the mandate he needs to pursue structural reforms.

In recent months, most analysts have forecast that the yen would strengthen to around 90 to the dollar by the end of the year. Instead, the yen plummeted to a 16-month low in October of more than 114 to the dollar, and analysts rushed to downgrade their forecasts for the currency. What happened?

“The answer to the puzzle of the declining yen is largely an interest-rate story,” says Ashraf Laidi, chief currency analyst at MG Financial Group in New York. “Signs of strength in the US economy have made the Federal Reserve increasingly worried about inflation,” he says. “The Fed is firing on every cylinder to fight inflation.” The already significant yield advantage of US treasury notes over European and Japanese debt will increase, he adds.

Despite months of uninterrupted net foreign inflows into Japanese equities, Japanese investors have been even bigger net buyers this year of foreign bonds, which offer much more attractive yields than are available in the domestic bond market.

Meanwhile, higher energy prices have increased buying demand for dollars from Japanese importers, which is a significant factor in the foreign exchange market at present, says Robert Lynch, senior vice president and head of Group of 10 foreign-exchange strategy at HSBC Bank (USA) in New York. And while Japanese interest rates have been rising, with the yield on the 10-year Japanese government bond climbing to a one-year high of 1.57% in October, the rise has been matched or even exceeded by increases in US interest rates, he notes.

This has been particularly true in the case of shorter-term securities, keeping the “carry” well in favor of the dollar, Lynch says. In the yen-carry transaction, investors borrow at low interest rates in the Japanese money market to invest in higher-yielding securities, such as US treasuries and emerging-market debt.

The dollar is stronger in general against a range of currencies, and the same interest-rate profile of higher US rates is supporting the dollar against the euro, Lynch says.

In recent speeches, Federal Reserve governors and officials have revealed a distinct shift in their perceived risk of higher energy prices from a possible drag on growth to a potential inflation risk, Lynch says. As a result of these comments, market participants are increasing their Fed-tightening expectations, as revealed in the federal funds futures market, which in early October forecast the Fed’s key short-term rate to rise to a peak of 4.5% by the end of April 2006.

Meanwhile, the Bank of Japan is debating when to end its policy of quantitative easing, whereby it targets the availability of credit and floods the market with liquidity rather than aiming to achieve a specific interest-rate level. Toshihiko Fukui, governor of the Japanese central bank, says he does not entirely dismiss the possibility that quantitative easing could end before the beginning of the next fiscal year in April 2006.

“Any change in Japanese policy will be very gradual,” says Laidi of MG Financial. “First, the BOJ will withdraw liquidity, and eventually it will resort to raising rates.”

According to Laidi, China will revalue the yuan again by the end of this year, which will help in capping the dollar’s rise. China revalued the yuan by 2.1% against the dollar on July 21. The US Treasury delayed its semi-annual foreign exchange report until early November. The report likely will criticize China for its lack of greater currency flexibility but is not expected to name China as a currency manipulator.

In late September China announced the widening of the yuan’s daily trading band against currencies other than the dollar, such as the euro and the yen, from 1.5% to 3%. While the change allows bigger moves in non-dollar currencies on a short-term basis, it does not represent a further revaluation of the yuan. The People’s Bank of China made no change in the tight trading range between the yuan and the dollar.


Support for the dollar from higher yields remains finely balanced against the structural deterioration evident in the US current account balance, says Bankim Chadha, global head of macro foreign exchange research at Deutsche Bank. The dollar’s rally this year has been a counter-trend move and not a turning point in the longer-term trend toward a weaker dollar, he says. Worries about the widening US current account deficit will come to the fore again before too long, he adds.

“If interest rates tickle your fancy when it comes to currencies, then the near-term outlook for the dollar is quite good,” says David Gilmore, economist and partner at Essex, Connecticut-based Foreign Exchange Analytics. The US economy must slow, however, and the savings rate must rise in order for the trade balance to improve, he says.

 

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