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What's With the Yen?

(August 5, 2010)

Dear Subscribers and Readers,

In our commentary on the Japanese Yen on July 15th (“The Next Yen Carry Trade?”), we asserted that while “the current level of the US$/Japanese Yen seems to have discounted most of the potentially bearish news in the U.S., and potentially good news from Japan,” it was still not the right time to go short the Yen versus the US$.  Again, subscribers should note that the US$/Yen exchange rate has historically been correlated with the differential in the US and Japan short-term rates.  As a result, we should focus on relative interest rates around the world rather than the attractiveness of global "risky assets” (including global equities).  Because of this correlation – and because of the expectation that the Federal Reserve would announce a further easing in its monetary policy at its next FOMC on August 10th – the US$/Yen exchange rate has continued to struggle.  Moreover, the ongoing “tug of war” between the Bank of Japan and the government (where the former has constantly accused the latter on spending on wasteful infrastructure) has resulted in a “non-activist” Japanese monetary policy.  On a brighter note for the folks who shorted the Yen against the US$, the latest monetary release shows that the year-over-year growth Japanese monetary base has accelerated to 6.1% at the end of July, its highest growth rate since August 2009:

Also note that the absolute level of the Japanese monetary base (not shown in above chart) is now at its highest level since April 2006 – when the Bank of Japan was still officially engaging in a “quantitative easing” policy!  As a result, while I still believe that one should short the Yen (i.e. use the Yen as a funding currency) and go long various Asian currencies whose countries have strong government and household balance sheets (e.g. Malaysia, Indonesia, Thailand, and India), I also don't think there is much upside in the Yen versus the US$ anymore.  A good turning point would be after the publication of the FOMC press release next Tuesday – as while there's a good chance the Fed could ease by utilizing any remaining room in their balance sheet (i.e. the $1.25 trillion agency MBS limit) to purchase U.S. Treasuries – I do not believe the Fed would announce any new liquidity facilities, given the resilience of the U.S. stock market in the last few weeks.

In addition, the US$/Yen exchange rate remains highly overbought.  In fact (as shown in the following chart), the Yen actually touched a 15-year high on Tuesday:

While the Yen could no doubt rise above its all-time highs of April 1995, I highly doubt that Japanese policy makers would stand back without some more easing or direct intervention should that occur.  The latest increase in the Japanese monetary base may be the first step toward this policy – but again, I continue to advocate going long the currencies of Malaysia, Indonesia, Thailand, and India versus the Yen, rather than going long the US$ versus the Yen as I believe the former currencies would be the benefactors of the next Yen carry trade.

Signing off,

Henry To, CFA

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