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Ad Hoc Comments on the Yen

(September 16, 2010)

Dear Subscribers and Readers,

I hope this finds all of you well. I also hope no-one got caught on the long side of the Yen—as we alluded to in our recent commentaries, intervention by the Bank of Japan was inevitable. And despite the relatively small amount (WSJ estimates this to be US$20 billion) of Yen sold on the open markets a couple of days ago, some traders: 1) were caught off-guard by the timing, and 2) are anticipating more intervention to come.

Make no mistake: Whether the BoJ is acting unilaterally or not does not in theory change the picture. Sure, if the actions were coordinated by the world’s major central banks, there would be more political will and global support behind the intervention. But a country that wants to weak her own currency has unlimited “firing power,” so to speak, as it could print an unlimited amount of its own currency in order to create inflation and lower real interest rates, and thus encourage her populace to seek higher real yields in foreign securities (hence creating another round of the Yen carry trade). Also note that the BoJ did not “sterilize” the latest round of Yen selling. In other words, unlike its interventions in 2004, the BoJ printed more Yen and let it circulate—which is another form of quantitative easing. Japan—being the world’s third largest economy—also has the power to stimulate the global economy through selling trillions more in Yen, thus encouraging global investors and her own populace to seek higher yields in riskier securities such as global equities or emerging market sovereign debt.

In theory, the BoJ could announce a commitment to sell, for example, as much as US$337 billion of Yen to stem the rise in her currency (this is equivalent to US$1 trillion adjusted for the size of the Japanese economy relative to the U.S. economy). Since the Yen is already overvalued (Goldman believes that the Yen is overvalued by more than two standard deviations on a purchasing power parity basis), I believe such a move would easily stem a further rise in the Yen (printing US$337 billion worth of Yen is also sizable enough to stimulate the global economy, assuming the BoJ does not sterilize any of its Yen selling). The fact that everyone is still bullish on the Yen is also encouraging from the perspective of the BoJ (although I hardly think Japanese policymakers know about the effectiveness of contrarian analysis!). Practically speaking, however, the effectiveness of any future Yen selling depends on the resolve and political will of Japanese policymakers. E.g. does it realize that it needs to solidly stand behind its policy and sell trillions more in Yen? US$20 billion is a drop in the bucket—I believe the BoJ would need to sell at least ten times this amount to fully reverse the bullish trend in the Yen. Can it do this in the face of criticism from the European Central Bank (U.S. policymakers have been relatively quiet about the intervention)?

In other words, the BoJ has the power to stem the rise in the Yen, but whether it does so depends on the political will, the resolve, and the financial shrewdness of Japanese policymakers. And from the standpoint of the latter, the Japanese certainly does not have a great track record!

I expect the Bank of Japan to sell more Yen in the next few business days. If it doesn’t, then I’ll have to question its resolve and political will. I maintain that the next great “carry trade” is an intra-Asian carry trade through purchasing a basket of emerging Asian currencies (those of Malaysia, Thailand, Indonesia, and India) and funding this basket by selling the Yen. For now, we will take a wait-and-see attitude.

Finally, I apologize for the “ad hoc” nature of this mid-week commentary. Between the change in the weather and the frantic cramming of my CAIA Level 2 exam, I have been feeling under the weather and have not had time to write a more complete mid-week commentary. I promise I will do a better job this weekend!

Yours Sincerely,

Henry To, CFA

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