Yen's Kamikaze Flight Trajectory
Forget about the flight to the dollar at the peak of the financial crisis: the yen was the ultimate beneficiary. The endlessly quoted unwinding of the carry trade was a factor, but there may have been a more important force at play. As that force may now be under increased pressure, the yen may be in trouble. The force we are talking about is the free market.
How can market forces drive up the yen when Japan has been a leader in quantitative easing, the "art" of printing money? Japan epitomizes the battle between market and government forces. Left to its own powers, Japan's economy would have imploded after its asset bubble burst in 1990. While painful, the good news about a deflationary collapse is that you can rebuild; a collapse is also a brutal way of weeding out those with too much debt. Instead, the government has, to varying degrees, been fighting market forces ever since. However, as of late, the Japanese have relaxed their attack on free market dynamics, in large part as a result of weak leadership.
Fighting market forces can be extremely expensive: if market forces ultimately win - i.e. the collapse ultimately happens - it's possible for a country to destroy its currency along the way. Left to market forces, those with debt likely go broke. Left to policy makers, everyone may eventually go broke.
The yen started strengthening in the summer of 2007. In September '07, the prime minister at the time, Shinzo Abe, resigned after months of mounting political pressure. Abe had succeeded the very charismatic Koizumi, who was featured in various advertising campaigns throughout the U.S. promoting Japan. There have been three more prime ministers since Abe; there have been six finance ministers in Japan since August of 2008. With such a dysfunctional government, the government did not spend extraordinary amounts, nor did the government interfere much with the Bank of Japan. Indeed, it seems almost ironic that the Bank of Japan, historically prolific quantitative easers, was conspicuously absent when the most recent round of global "quantitative easing contagion" infected central banks around the world. Left to market forces, consumers preferred to save, bolstering the yen.
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In that context, the conventional wisdom that a country needs to have economic growth to have a strong currency is, in our assessment, wrong. Such a relationship only applies to countries that depend on foreigners to finance their deficits. In the U.S., foreigners finance the twin deficits; one of the reasons why the U.S. has economic growth as a top priority is to entice foreigners to keep financing U.S. deficits. Australia also has a current account deficit and, as a result, has a currency that is sensitive to economic growth prospects. Japan, however, traditionally finances its deficits domestically; as a result, the value of the yen is not very sensitive to changes in growth forecasts. The same can be said for the euro zone: because the euro zone does not have a significant current account deficit, in our assessment, the euro can do well in the absence of economic growth.
Another way to think about it is as follows: Fed Chairman Bernanke has repeatedly emphasized how going off the gold standard during the 1930s allowed the U.S. to recover from the Great Depression. In plain English: if you devalue your currency, take away the purchasing power of the people, you provide an incentive for top line economic growth. On the other hand, if you don't pursue a policy to intentionally weaken your currency, you may end up with lousy economic growth on the backdrop of a much stronger currency. Japan and the euro zone are prime candidates for that.
Except that the story may not have a happy ending in Japan. Japan's ability to finance its deficit domestically is limited and may run out in the coming years. At that point, Japan's currency may be crushed given the weight of government debt. But rather than pondering about the end game, we are concerned about the years leading up to that point.
In September 2009, the then opposition Democratic Party of Japan (DPJ) swept to victory, unseating the previous government that had been in power with barely any interruption since 1955. DPJ's success was to a great extent a reflection of the failure of the previous government; their party manifest was about cutting "wasteful" spending, but then turning around to spend it on the "right" priorities. Known for fiscal conservatism and a hands-off approach to the Bank of Japan, 77-year-old Hirohisa Fujii was appointed Minister of Finance. In early January, Fujii resigned due to health reasons; when his successor, Naoto Kan, was appointed, we announced the yen had lost its status as a hard currency. What happened?
Aside from a couple of Japan-specific issues, such as shifting power from bureaucrats to politicians, the new government has struggled to find its course. As the realities of governing are setting in, the appointment of Kan as finance minister was the trigger for us to suggest that the DPJ has gained focus. That focus suggests boosting economic growth through greater fiscal spending, a more interventionist approach to managing the private sector; and greater meddling with central bank policy to boost economic growth. And, no, the Japanese are not copying the U.S.; Japan is a leader in fiscal spending and quantitative easing; Japan had merely taken its eyes off the ball in the past two and a half years. The focus is back on now - the yen may have been placed on a Kamikaze mission.
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We are not suggesting the yen will fall off a cliff tomorrow. Indeed, the yen's risk-return profile may provide valuable diversification benefits to select portfolios. However, we have stripped the yen of its hard currency status - a status the yen had only earned during the run-up to the financial crisis. As a result, we have eliminated the yen not only from the Merk Hard Currency Fund (MERKX), but also from the Merk Asian Currency Fund (MEAFX). For the Merk Absolute Return Currency Fund (MABFX) that seeks absolute returns by investing in currencies, the investment process is foremost driven by a quantitative model, supplemented by a risk and macro overlay; MABFX currently has neither a long, nor a short position in the yen. Currency exposures are subject to change without notice.
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We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.