The Yen Paradox
Posted on: 17 August 2017 , by: Darren Sinden , category: Market Review
Late in the evening of Sunday 13th August, some startling economic data "hit the tape".
Night birds in London or Tokyo based traders already at their desks might have blinked twice and questioned the data which revealed that the Japanese economy had grown by +1.0% (and +4.0% on an annualised basis) in the second quarter of 2017.
Yes, you heard it right +4.0% annualised!
Moreover, this was the sixth straight quarter in which the Japanese economy has grown. As a consequence of this data, Japan has leapt straight to the top of the G7 growth table (with only China growing at faster rate, among the world's major economies).
After decades of stagnation, could the Japanese economy finally be turning around? And if it is, what will this mean for the Yen, the architects of the recovery PM Shinzo Abe and Bank of Japan Governor Haruhiko Kuroda?
What's happening to Japanese GDP?
So just what’s been going on behind the scenes in the Japanese economy to drive this impressive growth? Is it sustainable? And how does it compare to the country's historical growth data?
When we dig down into the data we find that there were contributions from both consumers and industry. Consumers have been spending. Household consumption rose by +0.5% in the three months to the end of June 2017. We can clearly see the sharply rising trend in household spending in the chart below.
Business has made a contribution as well with CapEx or capital expenditure rising by +0.4% and overall business spending is up by +2.4%. We can clearly see the improvement in business confidence in our second chart which plots that metric against the country's rate of GDP growth.
Both of these items are trending higher and the economy is also becoming more productive with both nominal per capita GDP and the inflation adjusted per capita figure rising. Though that data needs to be viewed in the light of Japan's decreasing population.
Unemployment fell to just 2.8% in June this year, which effectively amounts to full employment. But tellingly, wage growth (see the dotted line rhs above) remains largely absent, as it has done over much of the last decade.
Inflation or rather the lack of it has dogged the Japanese economy for decades. Inflation has effectively averaged 0.00%, per annum, over the last 20 years.
The Bank of Japan has targeted an inflation rate of 2% per annum. But as of June 2017, prices in Japan were growing by just +0.4% percent YOY. As, in fact, they have done for three months in succession. Whilst that's certainly encouraging as we have not returned to deflation. The inflation rate remains well short of the central bank's targets. No surprise then that the BOJ has pushed back the date it hopes to achieve 2% to 2019. Structural issues in the economy and Japanese society as a whole alongside the pressures of globalisation, have kept inflation in check.
Structural and Social change
Of course, interest rates in Japan are in negative territory as part of the BOJ's attempts to stimulate the economy. In the hope of discovering saving and encouraging expenditure, amongst a populace that have historically been amongst the most efficient savers in the world. In Japan it has traditionally been women who have looked after a family's finances, hence the rise of the "Mrs Watanabe” meme, the stereotypical private investor, beloved of the foreign exchange and stock markets.
Women have, to a large extent been socially excluded from the Japanese workforce. In as much they were expected to marry, leave work and have children. And not return to their careers thereafter. But Japan's demographics have hastened much needed social change. A declining and rapidly ageing population has meant that women are now returning to work and helping to drive the recovery. In fact, there are now more Japanese women in the workplace than their American counterparts according to OECD data.
Interestingly, one of the most active cohorts of working women are in the age group of 55-64. As of May 2017, more than 60% of older Japanese women were in work or looking for a job. This is to be applauded but it may say more about declining living standards for the older generation in Japan than it does about changes in social attitudes.
Data from Bank of America shows that one in four of Japan's over 65s now live below the poverty line. A figure that is 40% higher than for the population at large. But whether through necessity or choice the return of older women to the workplace is one of the marginal changes that is making a difference to the Japanese economy.
Of course one of the pillars of the "Abeonomic" recovery has been the weak Yen. However over 2017 as a whole, the Yen has actually been strengthening, thereby undermining the export led weak Yen policy.
Why should the Japanese Yen appreciate when investors are receiving no income for holding it? And in some cases actually pay for the privilege. What's going on here exactly? The answer lies in the Yen’s status as a reserve currency, which in modern terms makes it a safe haven. Clearly, there is much debate about why the Yen has retained that status given the stagnation of the Japanese economy over the last 30 years?
We could argue for hours about that. But to put it simply it comes down to liquidity. The Yen is the third most liquid currency in the world (after the US Dollar and the Euro). One hundred trillion Yen is traded every day on world's foreign exchanges. The reserve status of the Yen is something of a double edged sword for the Japanese monetary authorities. As it means that they are not always in control of their own currency. Rather the Yen is often driven by external forces the so called animal spirits in the market. These are largely manifestations of greed and fear or "Risk On" and "Risk Off" as they are more commonly known.
The chart above plots Dollar Yen in blue, against a classic risk indicator, the 10 year US Treasury bond yield (shown in green). You can see that the two instruments move in harmony. In risk off periods bond yields fall and the Yen strengthens (the Dollar Yen rate reduces) as capital seeks a safe haven. But when risk appetites return those same bond yields rise and then Yen weakens once more (the Dollar Yen rate rises). If Japan's economy can maintain its recent momentum and inflation stays in the positive territory then market attitudes towards the currency may undergo a subtle shift and the Yen could come to be seen as being worth owning in its own right. And not just a bolt hole during markets storms. Recent tensions over North Korea put the safe haven Yen centre stage once more and Dollar Yen printed $108.724 as a result but as those tensions receded so the Yen back above 109 and then 110 against the Dollar. The issue, for Prime Minister Shinzo Abe and BOJ Governor Kuroda, would come if safe haven flows coincide with a wider market appetite for the Yen. In which case we may see a reprise of the type of Yen strength we witnessed in the first six months of 2016. If that persisted it could hamstring the export led side of the economic recovery in Japan.
Of course if the Japanese economy lapses and its behaviour falls back into the bad habits that have dogged it since the late eighties and early nineties, then the Yen may weaken once more. Ironically that would be a reward for failure, an economic moral hazard if you like. Because the weaker Yen would likely drive export growth once more, providing enough impetus to keep the economy in stasis but not enough to fully resuscitate the patient.
Dollar Yen has moved by 5.4% year to date and there is every likelihood that we will see continued volatility or trading opportunities, in the pair and the other Yen crosses over the balance of 2017 and into the New Year. When both Shinzo Abe and Haruhiko Kuroda are due to stand for re-election.
The inner workings of Japan may remain a mystery to outsiders but the currency should always be close to a trader's heart.
For more analysis, you can check out Darren's Daily Market Update (key market news in minutes).
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