Chaos theory holds that isolated events can ripple throughout the world in unexpected ways — i.e. a butterfly flapping its wings in China can cause an environmental disturbance in Brazil. This week, we've seen the theory borne out in the currency markets. The devastating earthquake in Japan is likely to have a series of economic effects that will come as a surprise to observers. We're already seeing one such manifestation of chaos theory in the currency markets.
In the past week, Japan's currency has strengthened significantly against the U.S. dollar. Here is a three-month chart of the dollar against the yen.
As Aaron Task and I discuss in the accompanying video, that's a counterintuitive performance. Why? Many factors help determine the relationship between currencies, including relative interest rates and growth rates. But at first blush, it would have been a no-brainer that the yen would weaken against the dollar after the earthquake. Why? The huge damage of the tsunami and the continuing nuclear crisis is likely to take a big bite out of Japan's growth rate. As Reuters reported, Credit Agricole economist Susumo Kato said the events could knock Japan's fragile economy into recession, sapping growth by 1.2 percent in the second quarter of 2011. "Kato, like many analysts, suggested the damage could amount to 15 trillion yen ($188 billion), or around 3 percent of GDP." Lower growth tends to weaken currencies.
In addition, the Bank of Japan has responded with measures that, taken on their own, would contribute to a weaker currency. As central banks generally do in times of crisis, the Bank of Japan has flooded the nation's banking system with cash. "The Bank of Japan has pumped roughly 45 trillion yen (nearly half a trillion U.S. dollars) into its financial system and expanded its purchases of securities to support asset values," as Thomas Lauricella wrote in the Wall Street Journal. That includes a program under which it will print money to buy government bonds, corporate bonds, and stocks (through exchange traded funds). In ordinary times, such volumes of money creation would tend to weaken a currency and raise interest rates.
But these aren't normal times. As we've seen time and again since 2008, normal rules about the relationship between monetary policy and inflation and currency performance can get tossed out the window under extraordinary conditions.
Meanwhile, there are countervailing forces that might help push the yen higher. The reaction in the aftermath of natural disasters that disrupts supply chains and the normal course of events is frequently a sort of panic. We go from a just-in-time world to a world of storage. Run out and stock up, make sure they have enough food, water, fuel, resources to get through the next period and deal with the altered reality. The same happens with money. When bad things happen, whether it's in the Middle East or in Asia, people tend to repatriate money. Investments held overseas — be it in Swiss bank accounts or in the form of U.S. bonds or shares of IBM — tend to come home. People want to get liquid. And so Japanese investors who want to raise cash have probably been selling holdings denominated in foreign currencies, and using the proceeds to buy yen. That provides a sudden source of demand.
A similar mentality provides a few other sources of deman for yen. Think about insurance companies. The damage has been massive. Japan is an advanced, highly developed economy, in which property, businesses, and lives are very likely to be insured. Insurance companies invest premiums in assets, frequently in bonds. And since Japan has been a low-yielding economy for decades, Japanese insurance companies (or foreign insurance companies doing businss in Japan) have plenty of investments overseas. Now they have a sudden need to raise cash. They will have to make good on thousands of life insurance policies, and pay out on an amount of damages yet to be determined. Damages have been estimated at close to $200 billion, and, depending on what happens at the nuclear power plants, could be higher. That means they are bringing lots of cash into Japan, selling assets abroad and buying yen.
Here's a long-term chart showing just how low it is.
Of course, speculation always plays a role in the movement of currencies. In theory, you would expect that speculators would be looking to dump yen and buy other currencies, given the hit the economy just took and the actions taken by the Bank of Japan. But a lot of professional speculators are engaged in what's known as the "carry trade." Investors around the world borrow yen in Japan, where interest rates are very low, and invest the proceeds in other countries and currencies where interest rates and yields are a bit higher — in U.S. bonds, Brazilian stocks, derivatives, you name it.
It's a risky strategy that can easily be undone by sudden, unexpected market moves. And in the wake of a disaster, investors tend to flee from risk. So it's possible that the tsunami and its aftereffects may have caused many investors to rush to unwind those trades — i.e. selling non-Japanese assets and paying back the yen-denominated loans. This activity, too, would also have the effect of pushing the yen higher.
After recovering a bit after a wild trading day Wednesday, the dollar Thursday again lost ground against the yen. In a complex, highly interconnected world, it's unclear which factors are dominant in moving a currency on any given day. Much of the discussion about the effects of speculation in the currency markets is just that: speculation.