What was the most boring job in the foreign exchange market in 2011? To be the dealer in the USD/JPY currency pair. For the past six months, the pair traced out a mind-numbingly narrow range of 200 points, interrupted only occasionally by half-hearted attempts of the BOJ to intervene in the market. Despite suffering some of the worst natural and human-made disasters in history, which resulted in a massive hit to the Japanese economy, the yen continued to strengthen against the greenback, inevitably drifting towards the 75.00 level as 2011 came to a close. The rally in the yen was driven by two key factors – capital repatriation and quantitative easing from the Fed. In 2012, that trend will reverse only if the U.S. economy continues to rebound, driving U.S. interest rates higher. If on the other hand, the U.S. economy stalls and possibly even dips back into recession, USD/JPY could break below the key 75.00 barrier as the interest rate differentials between U.S. Treasuries and Japanese government bonds continues to compress.
Tough Year for Japan
2011 was a particularly challenging year for Japan. The country experienced one of strongest earthquakes on record which unleashed a tsunami that damaged its Fukushima nuclear power plant, triggering the worst disaster since Chernobyl. The damage had both human and economic consequences as the country’s supply lines were interrupted for months, causing severe disruptions in business activity. As a result, Japanese GDP contracted in the first two quarters of the year, declining by -0.9% and -0.5% before finally rebounding in Q3 to expand by 1.4%. Going forward, however, the economic rebound may be stymied by the persistent strength of the yen against both the dollar and the euro. Already, many Japanese manufacturers are considering relocating their plants outside the country as high-exchange rates compress profit margins. If this trend persists, it could result in higher unemployment in 2012. Although the unemployment rate steadily declined in 2011, hitting a low of 4.1%, it spiked to 4.5% at the end of the year, signaling that labor conditions may deteriorate next year.
Weak Economy Strong Currency
Despite recording some of the weakest economic growth numbers amongst the G-20 nations, Japan saw its currency appreciate relentlessly against the dollar as the year progressed. Part of the reason was due to repatriation as the Japanese brought some of its vast capital holdings home, in order to rebuild the damage from the earthquake and the tsunami. But by far, the biggest reason for the downward trend in USD/JPY was due to the Fed’s persistent quantitative easing policy. From November 3rd, 2010 until June 30th of 2011, the Fed committed 600 billion dollars to the second round of bond buying that drove U.S. rates markedly lower as the benchmark 10-year bond yield dropped from 3% to 2%. Meanwhile, the rate on the 10-year Japanese Government bonds also fell, but considerably less from 1.3% to 1%. Therefore, the interest rate differential between 10-year U.S. Treasuries and Japanese government bonds compressed by about 70 basis points. Because interest rate differentials are the single most important driver of trade in USD/JPY, the pair continued to weaken throughout the year.
Can Stealth Intervention Hold 75.00?
In 2011, the Japanese authorities made a few half-hearted attempts at intervention after the market consistently ignored their verbal warnings. BoJ would enter the market whenever USD/JPY came close to or breached the 75.00 barrier, which was considered to be the absolute lowest acceptable price for the export-driven nation. Its efforts, however, had only a minor and temporary impact as the pair quickly retraced its rally within several weeks. Lately, market speculation has centered on the idea that the BOJ may be engaged in “stealth intervention” by selling the yen in smaller, but still significant volumes without necessarily informing the public. Some analysts have reported that the BOJ has been conducting phone interviews and handing out questionnaires to Tokyo's financial institutions to see if the overseas branches of these institutions can take trade orders from the central bank, providing even more secrecy to their maneuvering. Essentially, the BOJ is taking a page from the successful campaign of the SNB and creating a de-facto peg at the 75.00 level to provide relief for its large manufacturers.
U.S. Data Drives The Yen
Ultimately, the fate of USD/JPY lies in the hands of U.S. monetary officials. The pair will not rally until U.S. monetary policy moves to a more neutral posture. With the Fed committed to keeping rates low at least through the middle of 2013, the chance of a sustained rally in the pair is remote. Most recent U.S. economic data has shown promise, but the rebound in business activity has been modest and is unlikely to convince the generally dovish board of Fed governors that U.S. monetary policy should become more restrictive. As long as the spread between the 10-year U.S. Treasuries and Japanese government bonds remains less than 150 basis points, USD/JPY will remain the most boring pair in the currency market, tracing out a range between 75.00 and 80.00. However, if global economic conditions deteriorate, pushing U.S. 10-year yields towards the 1% level, the pair will very likely break the 75.00 figure to the downside, frustrating BOJ efforts to maintain its stealth peg.