From late February to mid-August 2016, the yen staged a historic rally against the US dollar, going from 114 to 99 yen to the US dollar. Since then, the yen has backed off to 104.
Now the pundits are predicting another round of yen weakness. Don’t believe it. The yen rally has far to run.
To understand where the yen is going, a little background is needed…
From late 2012 to early 2016, Japan engaged in a deliberate policy of cheapening the yen against the US dollar, euro and Chinese yuan. This was an effort to stimulate exports and cause inflation in the form of higher import prices, especially oil.
This cheap yen policy was one of the ‘three arrows’ of Abenomics — named after Prime Minister Shinzo Abe — which were announced in December 2012. The intent was to give Japan a boost while it pursued more long-term structural and fiscal reforms. This was all part of a larger effort to lift Japan out of its 25-year depression of weak growth and periodic deflation along with multiple technical recessions.
Unfortunately, Japan wasted the opportunity. It relied entirely on the cheap yen and did nothing of substance in terms of structural reform or fiscal policy. The cheap yen policy became Japan’s one-trick pony when it came to stimulating growth.
Your correspondent in front of the Japanese National Diet Building in Tokyo during a recent visit to Japan. Despite calls from politicians for more monetary ease, nothing will be done. The Bank of Japan is prevented from rejoining the currency wars by the US and China and must deal with the resulting strong yen.
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Part of the international community’s support for Japan’s weak yen was the belief that US growth would reach a self-sustaining ‘lift-off’ as a result of more quantitative easing, which was started by the Fed in September 2012. This was the famous ‘QE3’ experiment by Ben Bernanke.
The Fed was so confident that QE3 would work that they announced an intention to ‘taper’ money printing in May 2013, and actually began the taper in December 2013. By November 2014, the taper was complete and Fed money printing by QE was officially over.
The Fed continues to print money to maintain its balance sheet at the current size by replacing maturing assets, but it is not expanding the balance sheet.
As usual, the Fed’s analysis proved completely defective. After QE3 ended, the US economy did not achieve self-sustaining growth. In fact, US growth has stagnated exactly the way it did after the end of QE1 and QE2.
By the way, this strongly suggests the Fed will have to launch a QE4 policy in 2017 to keep the US economy from going into recession.
By early this year, the US was stuck in a rut of 1.25% annual growth. That was well below Fed expectations of 2.5% and even further from US potential growth of 3.5%. The world’s second-largest economy, China, was also slowing dramatically.
Suddenly, it was time to pass the baton in the currency wars. Japan would no longer have the luxury of a cheap currency. It was time for the US and China to reap some of those benefits.
However, the problem with currency wars is that they are a zero-sum game. If one currency goes down, some other currency has to go up. It can’t be any other way. If the US and China were going to have cheaper currencies, then Europe and Japan would have to have stronger currencies.
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China, the US, Europe and Japan make up about 70% of global GDP. Together, they make up a potent G-4 inside the larger G-20 group of countries. Their currencies — the yuan, US dollar, euro and yen — are the only ones that really matter in the global currency wars.
All of the others are like small mammals dodging large predators. Sometimes they are nimble enough to escape, and sometimes they are roadkill.
This consensus on a weaker yuan and US dollar was the genesis of what became known as the ‘Shanghai Accord’. This was an agreement reached on the sidelines of the G-20 central bankers and finance ministers meeting in Shanghai on 26 February.
One important facet of the Shanghai Accord was that the peg between the Chinese yuan and US dollar would be maintained. China had attempted unilateral devaluation in August 2015 and December 2015. Both times, US stocks fell more than 10% in subsequent weeks. If China was going to devalue, it would have to be in lock step with the dollar against the yen and euro.
That way, the yuan-dollar peg could be preserved and US equities would not be threatened.
The Shanghai Accord worked brilliantly. The yen rallied from 114 to the US dollar at the inception of the Shanghai Accord to 99 to the dollar by mid-August 2016.
The problem with manipulating complex systems such as capital markets is that a manipulation in one dimension may cause unexpected and unintended consequences in other dimensions. The weak US economy and the weak US dollar policy resulting from the Shanghai Accord meant that the Fed was unable to raise interest rates at its March, April, June and July FOMC meetings.
As recently as last December, the Fed said it intended to raise rates four times in 2016, but so far there have been no rate increases at all.
The US stock market took the Fed’s easy money policy as a kind of ‘all clear’ signal and resumed its risk-on rally. The Dow Jones industrial average rose from 15,660 on 11 February, just before the Shanghai Accord, to 18,636 on 15 August.
That’s a spectacular rally of almost 20% in six months on the back of the Fed’s weak-dollar policy.
Now the Fed had a new problem. Stocks were pushing into bubble territory. Corporate earnings had been declining for over a year, and US growth and productivity were dropping also. There was no fundamental reason for a stock market rally except easy money. The Fed was worried that the stock market bubble would burst and destroy confidence for years to come, especially after stock market bubbles burst in 2000 and 2008.
The Fed sent out a host of regional reserve bank presidents and Fed governors to talk down the markets with threats of imminent rate hikes. The jawboning worked. Stocks stalled out in mid-August and the dollar rallied. As a result, the yen rally ended and the yen sank from 99 to 104 to the dollar.
Now the Fed faced another problem. The reality will not match their rhetoric. It may have been ‘mission accomplished’ for the Fed in terms of spooking stock investors, but the new stronger US dollar would choke US growth at the worst possible time.
The most powerful indications and warnings right now are that weak US growth will necessitate a weaker US dollar to provide some stimulus. In effect, the Shanghai Accord was laid to one side from mid-August to mid-September so that the Fed could cool off the stock markets.
Now it’s crunch time. The Fed did not raise rates at its September meeting. A rate hike at the 2 November meeting is also off the table — it’s too close to Election Day, on 8 November. That means no rate hikes until the December meeting, at the earliest, and probably not even then.
The Fed’s tough talk will be revealed for a sham. The reality of easy money will return. The dollar will weaken, and the yen will strengthen in tandem. The Shanghai Accord will be back in full force very soon.
This time, the yen will crash through the 100 barrier on its way higher to 95, or possibly even 90. That’s what it will take to weaken the US dollar enough to help the US out of its recessionary trajectory.
The much stronger yen is bad news for Japan. That’s the problem with currency wars. For every winner, there’s a loser. The G-4 have decided that the US and Chinese economies need a boost, and that will come at Japan’s expense.
Japanese politicians can’t stop the yen’s rise, and the Bank of Japan won’t lift a finger, because the US Treasury and the IMF have warned them off.
All the best,
For Markets and Money
Editor’s Note: This article was originally published in Money Morning.