Here is Jonathan ...
Every one of Japan’s neighbors is strengthening against the dollar ... what will it take to get the yen going again?
At this point, our answer is: it would take a near miracle. And we don’t see one occurring any time soon. Perhaps things will be different in 2008, but for 2007 the most likely outcome is continued doldrums for the yen.
Consider the following four prerequisites for a strengthening yen:
1. A vibrant economy. Everywhere in Asia, currencies have strengthened in direct proportion to confidence in the domestic recovery process: rising incomes, a buoyant credit cycle, increasing domestic investment, etc. And sure enough, the last time the yen rallied was late 2003, when real GDP growth exceeded 4% y/y and investors around the world were getting excited about Japan’s “rise from the ashes”. Since then, however, the economy has continually disappointed, straining towards 3% real growth but then falling back before picking up and falling back once again. Of course the economy is accelerating in the middle of 2007 – but the 2.6% real growth pace of the first quarter of the year is still well below what we need to see to initiate a sustainable yen rally.
2. Inflation. We thought we were finally seeing the end of deflation a few times over the past five yers, when headline CPI growth broke through zero in 2004 and again in 2006, but every measure of goods and services prices is back in negative territory today. In fact, “core” inflation (excluding food and energy) has never once been positive since 1998, and the overall GDP deflator is still falling at a visible clip. Things have been almost as bad on the asset price side; the 2005 Nikkei recovery quickly petered out, and since then Japanese stocks have been the worst performers in Asia. Nationwide land prices are still falling, and new commercial and residential construction starts have slowed visibly over the last four quarters. These are not exactly the most compelling trends to support the value of the national currency.
3. Rising interest rates. The current 450 basis-point gap between short-term Japanese rates and short-term US rates is a powerful incentive for global investors to play the “carry trade”, borrowing in yen and investing in US or other high interest economies – which, of course, pushes the yen even weaker. With moderate growth and no sign of positive inflation, it’s nearly impossible for the BoJ to undertake anything more than very token rate hikes – and while we’ve been waiting for the US consumer to show signs of weakness so the US Fed would be encouraged to cut rates, so far there’s no real indication of a consumer slowdown (and inflation remains on the high side in the US economy as well). Even the recent sub-prime debt turmoil has not yet made a big dent in US economic strength.
4. Domestic support. Finally, we need Japanese residents to invest their portfolio assets at home. For the past few years, however, the trend is just the opposite: Japanese firms and households have discovered other high-yielding markets, for example New Zealand debt and Indian equities, and have started to move assets offshore in ever-larger amounts. The resulting portfolio outflows are a constant source of weakening pressure on the yen as well – and they also discourage foreign exchange traders from taking long yen positions, since they don’t want to be caught betting against 127 million Japanese citizens going the other way.
And the key is that none of this is going to change any time soon. We do expect continued recovery in the overall economy, but weakness in crucial areas like domestic construction suggests that the recovery will be moderate. As we noted above, inflation remains a disappointment, and the Nikkei index is still a big underperformer. The Bank of Japan may well undertake another small rate hike in the second half of this year, but so far the Fed shows no sign of throwing in the towel, which means it will be a long time indeed before interest rate gaps close in a meaningful way. And those domestic portfolio outflows are still accelerating. The bottom line is that it’s going to take a lot of work from here to push the yen into a sustained, significant strengthening .... so please don’t hold your breath.