Japanese Yen RevaluationDan Norcini
This is especially true regarding the Japanese Yen for the primary reason that the Bank of Japan has a formidable arsenal at its disposal when it comes to official intervention in the Forex markets particularly if they intend to weaken the Yen at the expense of the Dollar. Without getting into the details of the actual mechanism as to how this is done, suffice it to say that they are feared and respected among Forex traders for good reason. One thing currency traders learned late last year and earlier this year is that the BOJ is not the least bit shy when it comes to announcing their intentions nor are they reluctant to pull the trigger and let the specs know exactly where they have drawn the line in the sand saying, "thus far shall you go and no further". They managed to successfully institute a type of "quasi-peg" with the yen preventing it from strengthening much beyond the 105 level. Time and time again the BOJ would come out of its chamber like some sort of angry behemoth and smash any attempts by speculators to drive the yen above that level. All bids were simply overwhelmed with huge offers and down she would go. Apparently, they finally grew tired of toying with the hapless speculators and decided to thrash them soundly once and for all which they did in February of this year (I should know as I was on the receiving end of that and am still carrying the scars). They literally inundated the Forex arena with offer after offer until they set in place a massive panic among yen traders who bailed out en masse of their yen long positions precipitating an exodus of the giant hedge funds who had amassed a sizeable long position against the sickly dollar. The Yen has yet to recover from that beating even after six months.
The question of course if is why did the BOJ seem so determined to cap the yen rally? The answer is because it suited their purpose. To their credit, unlike the denizens lurking in secret at the Federal Reserve who love to utter incoherent and cryptic messages which apparently none but the initiated can unravel, the BOJ officials, alongside of the Ministry of Finance officials, stated quite clearly that they desired a weak yen for the benefit of their export markets. Japanese domestic demand was and is still comparatively weak and thus the export segment of their economy has become their main priority. It is essential that they take the necessary steps to see that any hindrances to that particular segment are summarily dealt with and removed. A weak yen facilitates the sale of Japanese manufactured goods abroad and thus a weak yen it is! Simply put, that is where we are at today. The BOJ seems quite content with the current level of the yen vis-à-vis the dollar and has been very quiet of late. Gone are the reporters waiting outside the offices of the various finance authorities waiting with bated breath for the next pronouncement as to official intentions. It is reminiscent of the quiet after a storm.
Notice the following chart compiled from data collected on the Bank of Japan's web site. It will illustrate my point in regards to how a weak currency facilitates export demand by keeping exports competitively priced on the international market. As you can see, since 1998, the Japanese have managed to keep the price of their exported goods relatively cheap. Year on year percentage changes have been negative with very few exceptions. In other words, they have managed to keep the price of goods made there falling at a steady pace. It is obvious that this factor has greatly contributed to Japan's enormous trade surplus.
Still, I wonder if perhaps something is occurring which might interrupt this idyllic setting sometime within the next year or so. That something is the price of crude oil. You see, a weak currency is a double edged sword that can cut both ways. Currency weakness makes goods produced domestically and then sold abroad become less expensive helping to generate export demand. On the other hand that same weakness also serves to bring about inflationary pressures at home. To illustrate exactly how this two-edged sword works, observe the chart of the Japanese Import Price Index. Do you notice the sharp increase this year in the cost of imported goods?
Now, take a look at what might be called the Japanese equivalent of our Producer Price Index or PPI. Notice the steady but sure rise that has begun to occur at the wholesale level in Japan. This has yet to apparently filter through to the consumer level but it is inevitable that it will. I believe the reason for this inflationary rise at the wholesale level is directly related to the weak yen policy that the Bank of Japan has been following in order to keep their export sector healthy. In effect, they are experiencing the other side of that two-edged sword I spoke of earlier.
Think about it this way - to manufacture goods, one must first obtain raw materials on the international market. Since many of these goods or commodities are priced in U.S. Dollar terms, the same weak yen that is serving to facilitate Japanese exports is also resulting in imported inflationary pressures. A weak yen may help the Japanese manufacturers of electronic components sell those to the U.S. market, but those same manufacturers must first buy the copper wire that makes up the circuitry of those devices along with any other metals such as silver or even gold. The weaker the yen becomes, the more expensive input commodities become for those manufacturers. The result is the general rise we see taking place in wholesale prices in Japan. It stands to reason that eventually these costs are going to have to be passed on to end users if manufacturers are going to preserve their profit margins.
I am of the opinion that the rise in crude oil prices has been particularly hard on the Japanese economy. A nation such as Japan which has little to no domestic supply of oil that I am aware of, must import all they need from abroad. Since crude oil is priced on the international market in dollar terms, a weak yen serves to aggravate an already rising oil price making it that much more expensive on the Japanese home front. There is no doubt in my mind that one of the primary reasons for this rise in both imported goods prices and in wholesale prices has been the surge in crude oil this year. Throw a weak yen into the mix and you have a real recipe for a definite shock to the Japanese economy.
With this in mind, I am beginning to wonder if at some point in the not too distant future, we might perhaps see the BOJ and Ministry of Finance agree to allow the yen to revalue upward against the dollar to cushion the shock of high oil prices. They are definitely going to be caught in a high wire act of walking a tightrope between trying to keep their export sector going strong while at the same time trying to avoid the dampening effect that rising prices will have on their domestic economy. Japanese consumers are famous for their thrift habits of saving and it has been almost like pulling teeth to induce them to part with their disposable income at times. If the price of goods begins to rise domestically, there is a very good chance that the nascent recovery in Japan could very well stall unless wages keep up and that might well create a type of vicious feedback loop.
Please keep in mind that this is all based on the supposition that crude oil prices are going to continue to stay relatively high. Given the long term repercussions of increasing demand on a steadily decreasing supply which seems to have peaked according to the studies that I have read, it is hard to imagine crude oil prices below $30/bbl anytime in the immediate future barring a complete collapse in China which I simply do not believe is going to occur.
To illustrate how the BOJ could react to a crude oil price that has reached a new plateau and a higher trading band, examine the chart below to see the effect of a 20% upward revaluation in the Yen against the Dollar.
Notice the blue line first. This is the actual price of crude oil as it is denominated in Yen terms. It is obvious by any standard of measure that the rise in crude has severely taxed the Japanese economic recovery, like the rest of the industrialized world, judging by its steep rise and especially since September of 2003. Now observe the dark grey line just below. That line is a visual representation of what the crude oil price would be in Yen denominated terms if the yen was to rise 20% against the U.S. Dollar. Please notice the significance of this. Crude oil prices could remain at these lofty levels and the Japanese could effectively drop the price of this critical commodity back to the same level it was trading at in March of 2003 merely by allowing the Yen to rise 20%. That is the advantage they enjoy as a result of crude being priced on the international market in Dollar terms. They could achieve a discounted price!
I should mention a complicating factor at play here however and that is the sheer enormity of Dollar denominated reserves being held by the Bank of Japan. If they allow the yen to rise to cushion external shocks to their economy such as rising crude prices or other assorted commodities, then they run the risk of watching their reserves erode in value as the U.S. Dollar falls in value. The Chinese face the same problem as well. I am of the opinion that at some point that both nations will begin to lessen their exposure to dollar denominated debt so as to give them more "wiggle room" when it comes to attempting to set the band within which their currencies will range. I know that some might scoff at the notion that the yen is going to be kept within a confined range but the simple reality is that the BOJ keep their "quasi-peg" in place quite effectively last year and earlier this year. Regardless, if we get any data that might indicate that they are beginning to move to diversify their reserve holdings, we could be getting the tip off that the upward revaluation of their currencies is imminent.
I must admit, the more I think about this subject the more I am amazed at the sheer complexity of the problem that has arisen in this arena. For both Japan and China to attempt to balance domestic needs against export related industries is no easy task especially when sitting on combined mountain of nearly $1 trillion in U.S. debt. Speaking strictly as a currency trader and a speculator, I personally despise the idea of Central Bankers intervening in the market place to alter the current valuations of their respective currencies. Truth be told however, I have come to understand why Central Bankers are constantly at war with currency traders. Those who attempt to fine tune the valuation of their currencies and lay their plans in secret are particularly disdainful of those whose actions tend to confound such plans.
One of the final repercussions of such a move by the Japanese and for that matter, by the Chinese as well, would be an increase in downward pressure on the U.S. dollar which would serve to benefit gold. Regardless of whether or not we like it, the dollar and gold are joined at the hip. I prefer to refer to gold as the "anti-dollar". It could very well be the catalyst that kicks the gold bull market into high gear. We will just have to be patient and see how long their appetite for U.S. paper remains intact.
Dan Norcini
August 28, 2004
Dan is a professional off-the-floor commodity trader residing in Texas and can be reached at dnorcini@earthlink.net with comments.
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