Has the Yen Bottomed?

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1 MAR Has the Yen Bottomed? Chen Zhao» I was strongly bearish on the yen, but I m becoming less so. A strong possibility exists that the yen could stabilize or even rally as part of the reprieve in the dollar bull market. Within a three- to six-month horizon, I believe the yen may stabilize or even strengthen, particularly against a range of Asian currencies and the euro. What has changed? First, the 36% drop in the yen-dollar cross since the beginning of 2013, when Abe Shinzo assumed power as prime minister, has started to redistribute nominal growth between the U.S. and Japan in a significant way. For instance, Japanese nominal gross domestic product (GDP) growth has been accelerating. On a quarterly annualized basis, Japanese nominal GDP growth spiked to 4.4% in 4Q This is significantly stronger than U.S. nominal growth, which averaged 2.5% for the same period. There has been a fairly tight correlation between Japan s nominal GDP growth and the trade-weighted yen value. According to Chart 1, Japanese nominal growth could continue to accelerate this year and in 2016, given the magnitude of the recent fall in the Japanese currency and the so-called J curve effect. If growth does indeed occur as is it s likely to the Japanese economy will look much more normal than at any other time in recent history.

2 It is worth noting that Japan s manufacturing business is doing particularly well, with exports showing the strongest growth. On the other hand, U.S. manufacturing has borne the brunt of a stronger dollar. Chart 2 shows that Japanese export growth has accelerated to over 10% from -5% in 2013; however, U.S. export growth has slowed to a virtual standstill from an 18% growth rate in 2011, at which time the dollar had bottomed out and began to rally. Second, market sentiment toward the yen is uniformly bearish, which is the mirror image of the very bullish U.S. dollar view held by the majority of investors in the financial community. Financial markets are crowded with yen shorts, which means the selling pressure on the currency may finally be exhausted, see Chart 3.

3 Third, in terms of valuation, the Japanese yen is probably the cheapest of the world s major currencies. The real effective exchange rate of the Japanese yen has decreased for decades due to the persistent fall in Japan s domestic price levels, which has amounted to steady depreciation in real terms. In fact, prior to its recent fall, the Japanese yen was already considered cheap based on most conventional measures of purchasing power parity (PPP) due to the persistent negative price-level gap between Japan and the rest of the world. Fourth, for more than three years the Japanese stock market has been closely correlated with the yen, a sign that the Japanese economy could not stand on its own without the help of a falling currency. This, however, may start to change. Chart 4 below shows that for the first time in a long while, the Nikkei seems to be breaking out without the support of a falling yen. Of course, the departure between the two markets is still in the very early stages, and therefore we should not hastily draw any definite conclusions. However, should the yen and the Nikkei indeed part ways, it could be confirmation that the Japanese economy has finally regained nominal traction. If so, this would suggest that the reflationary mission of a weak yen has been accomplished. The decreasing correlation between the yen and Nikkei could arguably erode the bearish case regarding the yen.

4 Japanese authorities are beginning to show some confidence over monetary policy. Bank of Japan (BOJ) Governor Haruhiko Kuroda recently indicated that he sees the central bank meeting its inflation target. BOJ Deputy Governor Kikuo Iwata has also expressed optimism on the uptrend in Japanese price levels, and has further stressed that the effect of the bank s monetary stimulus is working its way through the economy. Recent policymaker comments represent a significant change in rhetoric, from one of caution a few short months ago to a tone of increasing confidence. Therefore, I see diminishing chances of the BOJ making additional large-scale asset purchases beyond current commitments. In other words, the BOJ has limited scope to surprise investors and push the yen down further. The bottom line is that the yen may be bottoming against select currencies. Of course, with the Federal Reserve contemplating when to raise policy rates and the U.S. economy remaining on an expansionary path, the yen may not strengthen much against the dollar. However, the Japanese currency could rebound against a range of Asian currencies, such as the Korean won or the New Taiwan dollar. The euro-yen exchange rate is also vulnerable on the downside. Compared with the magnitude of the yen s decline, the euro s recent fall is very modest and will probably not be enough to stabilize nominal growth in the euro zone. Although some small and incremental improvements are occurring in the euro-zone economy, the euro-zone system still needs fixing. Policy paralysis and political bickering will not simply go away, and the slow pace of reforms means that the European Central Bank needs to keep the euro weak. Despite these hurdles, the euro-yen exchange rate stands at the multi-year highs, and the euro is much more expensive than the Japanese yen.

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