The Backdrop
With the passing of the Bank of Japan Act in 1882, the Bank of Japan (BOJ) was officially established as the nation’s first central bank and is one of the world’s oldest central banks.
In Japan, the government does have an effect on policy and the Governor of the bank must work together with the Prime Minister in order to be effective, which will ensure that the nation’s monetary policy will fit with the government’s economic policy. While the new legislation provided some separation between the two institutions, they are still linked. For instance, the Bank of Japan’s budget must still be approved by the government. Regardless of the new laws, in order for the bank to achieve its goals, collaboration between the Governor of the bank and the Prime Minister is required.
The Bank of Japan’s decision making body is known as the Policy Board, which consists of the governor, two deputy governors and six other members. All nine members are appointed by the Cabinet, Japan’s executive branch, and approved by the Diet (the legislature) for a term of five years. The Policy Board meets frequently, but two meetings per month are solely dedicated to discussing monetary policy. Decisions on monetary policy and on how to achieve the bank’s goals are made through a majority vote of the Policy Board.
The BOJ’s first mission is to maintain price stability. In other words the goal is to create a situation where there is neither inflation nor deflation. In order to achieve this, the bank conducts monetary policy by buying or selling securities on the open market and altering the interest rate.
The second mission of the BOJ is to ensure the stability of the financial system and to develop the economy. In order to achieve this, the bank engages in the following activities: issuing banknotes, providing settlement services, international activities, government securities operations, and compiling economic data.
How the Bank of Japan Affects the Foreign Exchange Market
The Japanese economy is very dependent on importing and exporting goods and services. Nearly all of their natural resources, such as oil are imported and a large portion of their businesses’ products/services are exported. As a result, the Bank of Japan used to peg the Yen to the U.S. Dollar at a fixed rate in order to remain competitive in their exporting operations. Eventually, they allowed the Yen to float, but are still known to occasionally intervene in the Foreign Exchange Market and artificially manipulate the price of the USD/JPY. In the past, traders have taken advantage of their intervention and reaped tremendous profits, so it is important to follow the press releases of the BOJ for any hint of intervention.
Also, the BOJ’s interest rate decisions have a profound effect on the Yen’s exchange rate. For example, if the BOJ decides to raise the interest rate, then returns on Yen assets will appear more favorable to investors and the Yen will appreciate in value. This will create a situation where imports are cheaper for Japanese citizens and their exports become more expensive to the rest of the world.
The Progression of Carry Trades in 2007
Looking at the interest rate term structure for some of the most liquid currency pairs, one can easily see why the Australian and New Zealand dollars are the most sought after currencies in the carry trade world. Not only are both the Australian and the New Zealand economies benefiting from a recovery in commodity prices, but as a result market expectations are clearly skewed for more rate hikes. Market players will always seek the highest return for their investments and just because the USD/JPY carry trade doesn’t work as well now as it did in the past, doesn’t mean that the entire carry trade strategy is condemned. The rules of the carry trade require that you find currencies with both high interest rates and positive interest rate expectations.
Is the USD/JPY carry trade condemned?
Until very recently, long USD/JPY was the trade that everyone wanted to be in. While the Federal Reserve, struggling to control inflation, increased the price of money sixteen consecutive times, the Bank of Japan was fighting deflation by holding interest rates near zero. Consequently during 2006, the interest rate differential between US and Japan made long USD/JPY a one way bet. However, on February 27, 2007 all those gains and assumptions about the carry trade logic came to an end. An unexpected unwind of yen carry trades triggered both by a sell-off in the Chinese stock market and by rumors of margin calls affecting leveraged accounts, pushed the Japanese yen to record lows against the world’s most liquid currencies. Looking ahead, even though the US dollar still has a positive interest rate differential against the Japanese yen, interest rate expectations are visibly favoring the Japanese yen, what makes the USD/JPY a bad carry trade for 2007. Furthermore, the dollar could become the epitome of anti-carry. Many traders expect the Federal Reserve to start cutting rates and are currently hunting high yielding currencies like the Aussie and the kiwi at the cost of the US dollar.
The AUD/JPY May be the Best Continuation Carry Trade for 2007
While the Japanese economy continues to be very vulnerable to the economic cycles of the US economy, the Australian economy is on its sixteenth consecutive year of strong growth. Although the cost of borrowing in Australia is already among the highest in the world, unless price and wage pressures start to fade away the RBA could be poised to increase the level of interest rate even higher which may help the AUD/JPY break the 100 price barrier. On the downside of the Carry trade though, the recent plunge in USDJPY which shaved nearly 1000 points off the yearly highs in a matter of weeks has many currency traders wondering if there is more downside to come.
The drop in USDJPY was not caused by sudden divergence in economic fundamentals between US and Japan, but was driven probably by the liquidation of the carry trade. Looking at past instances of the “so called significant carry trade liquidation” in USDJPY such as the Asian financial crisis in 1997 or the 1998 downfall of Long Term Capital Management fund, the initial move down was inevitably followed by a retrace and then a thrust lower as the full impact of the unwind made its way felt though the global financial markets. Therefore the question to consider is the recent rebound in the pair. Could USDJPY trade as a low as 110 by year end? We examine several possible scenarios that could create that outcome.
Fed does NOT cut rates
With Japanese interest rates remaining miniscule at 50bp, even a half point rate cut by the Fed would still preserve a net 425bp positive interest rate differential between the yen and the dollar. If the Fed does not cut rates, the US equity markets could become more volatile as the higher cost of credit for consumers and corporations would likely contract demand and compress profit margins causing stocks to plummet. A sharp decline in equities would bring back another wave of risk aversion and along with it more rounds of carry trade liquidation pushing USDJPY lower.
If the Fed does maintain rates steady and if that in turn creates selling pressure on Wall Street as Dow slowly tickles down to 12,000 then USDJPY will likely follow suit as risk appetite is gradually curbed.
Dow Crumbles
The slow and steady drip is of course not the only way that the carry trade could crumble. Equity investors simply may not wait for the Fed to act and could push prices sharply lower if the problems in the credit markets persist. Given the fact that equity investors are approaching September and October - the two most seasonally turbulent months in the market a selling stampede is not out of the realm of possibility. A big fall in the Dow would no doubt trigger an immediate rate cut from the Fed but at that point it would most likely be too late, as the move would be seen as reactive. A massive decline in US equities would no doubt reverberate around the world causing sell offs in all the major bourses and triggering carry trade liquidation in it wake.
US Economy Slows Markedly
US economy is continuing to expand at a healthy pace registering better than 3% growth in the second quarter. However, the problems in the sub prime mortgage markets may just rub off on the economy as a whole. Don't forget that more than 38,000 mortgage related jobs are reported to be lost over the recent past due to bankruptcies and closings of a number of mortgage brokers. However, the longer term effects of the collapse of the housing sector may been seen in the decline of demand for consumer durables such as furniture, appliances and new automobiles, curbing consumer spending, as homeowners will be forced to allocate a greater portion of their income to debt service.
In short, the overhang from the housing sector collapse is likely to weigh on aggregate US demand and could potentially tip the country into a recession if the rate of foreclosures and bankruptcies accelerates markedly. In that scenario the Fed would need to aggressively and continuously cut rates until the economy stabilized once again. Should that occur much of the impetus for the dollar yen carry trade would be gone as traders would anticipate the persistent narrowing in interest differentials and pressure the pair lower.
Conclusion
As markets have stabilized over the past few days and risk appetite and along with it the demand for carry trade has come back, it is important to remember that past instances of carry trade liquidation always resulted in further declines after an initial retrace. Perhaps this time the situation may prove different and monetary authorities would be able to restore confidence in the markets while investors from China and the Persian Gulf absorb the risk of the credit failures in order to assure the continuation of global economic growth. However, the scenarios we’ve outlined above are quite plausible given the current market dynamics and currency traders would be well advised to consider them as they ponder the value of the carry trade at the new lower prices.
The future beacons
The Bank of Japan has for now, kept interest rates in the world's second largest economy on hold, helping to calm financial markets by keeping the cost of cash cheap after the US sub-prime mortgage debacle threatened a global credit crunch.
The nine member BOJ policy board voted to maintain its target rate on funds that banks loan to each other at 0.5%, the Japanese central bank announced at the end of a two day meeting in Tokyo.
The decision means Japanese banks will probably continue to lend funds in the inter bank market at rates 475 basis points lower than in the US.
BOJ governor, Toshihiko Fukui, has made no secret of his desire to raise Japanese rates and bring closer in line with those in other industrialised nations.
Excessively low Japanese interest rates have in the past sparked so-called carry trades, helping speculators reap profits by raising funds in cheap yen and investing them in higher interest bearing Assets in currencies like the Aussie, kiwi,dollar, pound and the Euro. The carry still rules the roost, with the Aussie and the Kiwi said to be the more favoured destinations.
The recent strengthening of the dollar against the Japanese currency though - to the ¥117 from the low of 111.61 in a matter of days suggests that speculators who had initially unwound their carry trade positions may be putting them back on.
The ongoing confusion in the international markets could mar any immediate (read September) rate rise in the Japanese Yen. Apart from looking to confirm less chaotic conditions in the international financial markets, Fukui san will probably also choose to wait until after the October 1 release of a major survey of business sentiment , known as the BOJ Tankan.
Although the Tankan is unlikely to suggest that the Japanese economy is getting radically better, the BOJ will at least want to confirm that things are not getting worse. If that happens there is a chance the bank could hike rates as early as October, but expectations point mainly at the same probably in November.
In any case expect the JPY interest rates to move up only up, given the low rates of interest currently. The EIU report, one of the more “reliable ” reports on current world economic situations, has in a recent report forecasted a USDJPY average exchange rate of around 117 this year (though they may scale down the same in the coming weeks, what with the recent turn of events) and 106 for next year. They have based the same on a long list of assumptions while emphasizing a great deal on the expectation of JPY interest rates moving up to 2.00 percent by 2008 end. They assume the rates to be revised twice this year and 4 times next year, every time escalating by around 25 basis points.
Past history, current market sentiments and my own gut feeling though rule that there may just be one 25 basis point hike by November and maybe a couple of hikes next year. Any further hikes may only be possible in a scenario of dramatic shifts in the Japan economy(which the writer believes is going a little too out of the way) and the world economy in general ( Don't forget the “Carry” though) and the US economy in particular( given the fact that US is the biggest trading partner for Japan). So there you have it. Expect the Yen to rule the Carry markets for now. USDJPY in the 114 to the 117 range in particular, and a broader range of 110 to 119 for the year. The Interest rate just managing to escalate up by 25 basis points, and a near neutral to neutral outlook on most economic indicators.
New direction to the markets?
11 years ago
