The Yen Continues to Surprise

There have arguably been two significant surprises in the capital markets this year, the strength of the yen and US Treasuries.  The two are related.  

The dollar-yen rate appears particularly sensitive to US interest rates.    The yen (not dollar) moves in the opposite direction of US 10-year Treasury yield two-thirds of the time of the past 60 days. and 70% of the time of the past 100 days. 

Traditionally, the other key relationship is with equity prices.  The correlation of the level of the yen and the levels of the Nikkei and S&P 500 are not statistically significant.  Running the correlation on the percentage changed basis is better. 

There is about a 51% inverse correlation between the percent change in the S&P and yen against the dollar.  For most of Q1, the inverse correlation was mostly in the 70%-80% area.  The inverse correlation with the Nikkei is a bit weaker at 46%, though this is the strongest relationship since the fourth quarter last year.  

 In response to the stronger than expected employment data last week, the US 10-year Treasury yield had firmed to almost 2.70%, its highest since late April/early May.  The dollar traded above the middle of the 2-yen range (JPY101-JPY103) that has largely confined the price action since late January.  The US 10-year yield is flirting with 2.50% today, and the dollar has slumped to the lower end of its range.   There have been four sessions this year that the dollar has traded below JPY101.  The first three were in early February, and the dollar recorded a low near JPY100.80.  The lowest close (NY session) was JPY100.98.  The last time the dollar traded below JPY101 was on May 21, when it spiked to JPY100.82, but closed just below JPY101.40.  

The US 10-year yield has fallen to levels that in the recent past has deterred new buying.  Even now it appears that the 10-year yield is recovering from the brief dip below 2.5%.  As this happened, the dollar found better traction against the yen. 

Of note, when the dollar rallied last week, implied volatility still fell.  Three-month implied volatility fell to a new low (since at least 1995) near 5.18% (according to Bloomberg).    As the dollar slipped this week, implied volatility has risen and now it is flirting with the 20-day average.  It has not spent much time above this moving average since late January/early February.    

After the high-yielding antipodean currencies,  the yen is the strongest of the majors, appreciating about 4% this year against the dollar and closer to 5% against the euro.    We have been skeptical of the ease at which market participants have been willing to accept the idea that expanding a central bank's balance sheet automatically translates into a weaker currency.   The theory is clear.  The practice isn't.  On a broad trade-weighted basis, the dollar  bottomed in 2011.     Aggressive QE by the Swiss National Bank was not very effective either, and officials shifted to a currency cap.  The BOJ had been expanding its balance sheet for years prior to Abe and Kuroda, but the yen did not weaken either. 

There have been a few pundits who suggest the BOJ may intervene in the foreign exchange market to drive the yen down.  Given the Japanese traditional penchant for intervening this may seem a reasonable guess.  However, it is wide of the mark.   After talking the yen down with specific targets in the early days of the Abe government, Japanese officials were criticized and forced to come to a new understanding with the G7.  

The BOJ meets next week.  No fresh action is likely to be signaled.  BOJ Kuroda has already warned investors that inflation is likely to ease this summer before rebounding (he says) before the end of the year.   Two important economic reports could prompt a cut in growth forecasts.  First, overall household spending continued to collapse in May (-8.0%) after tax-induced 4.6% drop in April.  Second, machine orders, a leading indicator for capex, slumped a record 19.5% in May (the market had looked for some recovery after a 9.1% fall in April. 

The Abe government argues business are not investing because the tax rate is too high.  We do not fully accept this.  We see many sectors of the Japanese economy suffer from excess capacity.  Growth is weak.  The population is not just aging, but its is shrinking as well.  Japanese companies do seem to be investing, just not in Japan.  Rather than cut tax schedules, Japan needs to cut the generous depreciation allowance.  That allowance essentially funds what investment is taking place in Japan.  This has helped allow Japanese coporates to amass JPY232 trillion of cash as of the end of the last fiscal year on March 31. 

In addition to the BOJ meeting, there is another event in Japan that will not be found on many calendars.  The Nuclear Regulation Authority may submit a safety report that will pave the way for possibly two nuclear plants to be re-opened.  All of Japan's nuclear reactors have been shut since the tragedy in 2011.  Restarting nuclear plants is very controversial in Japan.  One recent newspaper poll found the bringing nuclear plants back online is opposed by almost 60% of the respondents.  Ahead of this, several Japanese utility companies have been raising capital through bond sales.  In part, because of the importance of politics, the premium offered by utilities over government bonds tends to be larger than corporates generally.  Recently the premiums have narrowed more in line with Japanese corporates.  

The Nikkei has under-performed this year, after a stellar performance last year.  Year-to-date it is off 6.6%, the worst of the major bourses.  The FTSE 100 is the only other market index that has fallen this year (-1.1%).  However, the poor performance of the Nikkei is largely a Q1 phenomenon.  In the last three months, the Nikkei has advanced by 6.4%.  Last week, it reached the highest level since January near 15,500.    

Yet just as some have re-discovered Japanese stocks, technical factors warn caution is in order.  The Nikkei ran out of steam near a key retracement objective; the RSI and MACD indicators have not confirmed the rally in prices.   Both indicators are trending lower.  Today was the only the second time since the rally that began below 14,000 on May 21 that the Nikkei closed below its 20-day moving average.