How Did the Japanese Yen Trade in 2008?

The global economic turmoil and the subsequent unwinding of carry trades made the Japanese Yen, the best performing currency of 2008.  The Yen rose more than 35 percent against the British pound, Australian and New Zealand dollars and hit a 13-year high against the US dollar.  Unlike some of the other currencies, which may have seen wild swings throughout 2008, the Yen consistently strength throughout the year.  Unfortunately the remarkable rally in the Yen will also be a big reason why Japan could underperform, its peers next year.

Japan Could be the Worst Performing Country in 2009

Of all the countries in the developed world, Japan will probably have the toughest time in 2009 because of the strength of its currency.  As an export dependent nation, Japan typically runs a trade surplus but this year we have seen the country report trade deficits, which is extremely rare. Toyota, the world’s largest carmaker is the highest profile casualty of Yen strength.  The automaker reported their first lost in 70 years as sales plummeted and the Yen soared.  The toxic combination of a weak economy and a 16 percent rise in the yen against the US dollar has been disastrous for the automaker.  Although Toyota is probably the most high profile, they are certainly not the only major Japanese corporation to be hit by the double whammy of a slowing global economy and a strong currency.  Business sentiment across the country has already fallen to a 7 year low as exports decline by a record amount. Unless the Yen’s strength is suddenly reversed, we expect Japanese corporations to report more losses in the months to come.   As of the third quarter of 2008, Japan is in a recession with growth shrinking by an annualized pace of 1.8 percent. Next year, GDP growth is expected to fall by 2.5 to 4 percent as weak domestic and international demand hits the economy.  However it is important for currency traders to realize that the Japanese Yen does not always trade off economic fundamentals.  The outlook for Japan has been bleak for months now, yet the currency is rallying because risk appetite has been the dominant driver of the currency’s price action.  If the market is very nervous about the global economy, the Yen could still rise even if Japan’s economy continues to deteriorate.  

Inflation: Consumer Prices Could Turn Negative in 2009

Like the rest of the world, inflation is slowing in Japan, but consumer prices still remain in positive territory.  Nationwide, the latest data we have is from the month of November. During that month, annualized CPI growth slowed from 1.7 to 1.0 percent.  However the combination of a strong currency and the continual decline in commodity prices could drive consumer prices into negative territory next year.  A strong currency moderates inflationary pressures while a weak currency boosts it.

No More Room to Cut Interest Rates

With interest rates already at 0.5 percent in January 2008, we were surprised to see two obscurely sized rate cuts by the Bank of Japan that took interest rates down to 0.1 percent, within a whisker of zero.  Although the BoJ Governor denies it, the rate cuts combined with plans to buy commercial paper and increase purchases of government debt essentially returns the country to quantitative easing.  The only reason why the BoJ did not take interest rates to zero is because they do not want kill the repo market or give the public the perception that they have run out of ammunition.  Looking ahead, we have probably seen the last of BoJ rate cuts and the central bank will need to rely on fiscal policy and a further expansion of the balance sheet to stabilize the economy.

Will Carry Trades Recover?

Between 2001 and 2006, one of the most lucrative strategies in the currency market was carry trades.  However anyone long carry in 2008 was burned badly - GBP/JPY for example fell 41 percent to a 13 year low while NZD/JPY fell 39 percent to a 7 year low.  Record volatility, massive deleveraging and global interest rate cuts created a toxic combination for carry trades.  In order for carry trades to recover, central banks need to stop cutting interest rates, volatility needs to decline significantly and the global economy needs to recover enough for investors to be willing to start taking on risk.  This could happen in 2009 but not until the second half of the year at the earliest.  

Risk of BoJ Intervention

In the face of a deepening recession, a strong currency and little room to move on interest rates, everyone is wondering whether the Bank of Japan will physically intervene to weaken its currency. The problem is that the only type of intervention that has ever really worked is coordinated intervention and the BoJ will have a very tough time convincing the Americans and Europeans to take any steps that would strengthen their currencies.  Since the problem is not unique Japan and stems from the West, the Japanese needs to stand aside and allow the US and Eurozone governments to work on spurring their own growth.  If they weaken their currency and strengthen the dollar for their own short-term relief, it could actually be counterproductive. However with that in mind, as the economy worsens and the central bank runs out of options, intervention risk will grow.  

Technical Outlook for USD/JPY

As you can see from the weekly chart of USD/JPY, the sell-off in the currency pair has been severe. Currently, the price is well below the 200-week and 50-week SMA and at the level not experienced since 1995. This puts USD/JPY in the Bollinger Band sell zone and even though a retracement could imminent, it could be an opportunity to sell rallies than buy on dips. The closest level of support is at the 161.8% Fibonacci extension of a low established in late 2007 and the high for the 2008 at 86.50.  Resistance is at 94, the 10 week SMA.  

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