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What if it works?

A key question our friend Dave Dredge at Convex Strategies often asks policy officials in Japan about extreme measures (ZIRP, QE, YCC etc) is “what if it works”? Put another way, could Japan maintain their stable disequilibrium of yield curve control if the US dollar continued to rally to 160 or 200 to the Japanese Yen? While orderly currency weakness is positive for Japanese exporters, a disorderly or rapid depreciation of the yen might be a much different story for fixed income and equity markets. The key big picture point is that consensus belief among policy makers is that the adjustment to their desired inflation target will remain orderly. From our perch, that might be a heroic assumption.

Japanese policymakers have been attempting to engineer inflation higher over the past few years toward their target of 2%. However, they have been so “successful” that headline inflation is now close to the highest level in the last 30 years. Historically, there has been a relationship between the yen and headline inflation given the importance of trade and imported energy prices to the Japanese economy (chart 1). Therefore, it is plausible that a further and disorderly depreciation of the yen might lead to a self-reinforcing additional rise in consumer price inflation pressure.

Historically there has also been a strong inverse relationship between broad financial conditions and the yen as well. Of course, currency is a component of the Goldman index. However, it feels inappropriate to have financial conditions at close the most accommodative level in history with consumer price inflation at the highest level in 30 years (chart 2). The risk that it becomes unhinged is probably greater than what is priced or assumed by policymakers.

On the positive side, the Japanese equity market has been a stronger performer so far this year. The market is up 30% in local currency and is ironically still a “value” market relative to global equities. Although as we noted last week, it is satirical that investors in the Bank of America fund manager survey now “love Japan” after it has rallied 30% year to date. The good news as we have noted for some time that there has been a genuine improvement in trend returns to shareholders (profitability) over the past decade. That was at least partly driven by structural reforms in corporate governance. Return on equity has improved from less than 6% to over 10% (chart 3). Japanese companies (in aggregate) have net cash on balance sheet. Ironically, the surplus in Japan is in the corporate sector. For investors, Japanese companies have the capacity to further improve returns to shareholders via dividends and share buybacks.

The troublesome aspect of a major dislocation in the yen is that it has often preceded episodes of cross asset volatility. For example, May 1997 USDJPY drops almost 15 big figures in two weeks and a couple of months later the Asian crisis erupts, June 2007 two Bear Sterns credit funds implode ahead of the 2008 crisis or more recently in mid-2015 China devalues the CNY, and a major phase of market volatility erupts with the global growth scare in early 2016. The Japanese yen has often been the tip of the market iceberg. A key reason for this is that the country still holds a large amount of net foreign assets which tend to be repatriated in times of crisis. As we noted above, while an orderly depreciation of the yen might be bullish for Japanese equities, an episodic collapse in the currency could be catastrophic and lead to a major repatriation of Japan’s net foreign assets.


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