It’s the hottest trade in the world right now: betting the Japanese yen will decline against the U.S. dollar.
As part of the Japanese government’s new “Abenomics” strategy to lift the Japanese economy out of a decade of deflation, the Bank of Japan (BoJ) recently announced a massive quantitative easing program, unprecedented in scale.
Investors – especially those outside of Japan – have taken this as a sign that the Japanese government and the BoJ are serious about weakening the yen and inducing a little inflation.
A mini market crash caused by a fake AP tweet earlier this week showed how correlated the short yen trade is with risky assets in general right now. While the S&P 500 tanked in response to the tweet, the yen instantly strengthened against the dollar.
And since so many investors are now using the cheap yen – which has already weakened considerably in recent months – to fund carry trades in other risky assets, it’s important to consider what else could derail the short yen thesis, which has become one of the most “consensus” trades on the planet.
Société Générale FX strategist Alvin Tan says the biggest risk to the “widespread expectation of lower yen over the next several quarters” is pretty simple: a global slowdown in economic growth.
He uses the Swiss National Bank (SNB) as an example. Over the last 21 months, the SNB has expanded its balance sheet by an amount equivalent to 40% of Swiss GDP (the new BoJ program will fall short of that).
Yet the Swiss franc hasn’t weakened. Of course, the reason for this is the ongoing euro crisis and the flight to safety into Swiss francs that has caused the currency to appreciate. So, the comparison, considering the context, is not really apples-to-apples.
That is, unless you consider a scenario in which global growth enters a slowdown phase. And that happens to be a scenario that is beginning to generate a lot of buzz on Wall Street (see also: Why Everyone Is Rushing Into Bonds Again >).
Tan outlines the risk a global slowdown poses to the short-yen agenda in a note to clients this morning (emphasis added):
Nonetheless, this very simplistic juxtaposition of the external macroeconomic circumstances faced by Switzerland and Japan also helps to pinpoint the weak link in the consensus weak-yen view, namely the external environment matters greatly to the success or failure of BOJ super-QE policy.
Japan’s loan-to-deposit ratio is noticeably the lowest among all developed economies, yet domestic private credit growth has been flat for many years. As numerous commentators have noted, there is a credit demand problem in Japan, not a supply one. Given this, it is not immediately obvious that the BOJ will be able to boost Japanese domestic demand significantly through lower borrowing costs. The BOJ will have to rely on the net exports channel to lift growth through a weaker yen. Furthermore, a declining yen will also help to raise inflation expectations in Japan, again through the external sector.
Hence, the success or failure of BOJ policy will depend crucially on the external sector. If global growth falters, the BOJ is unlikely to succeed as net exports growth will suffer due to weaker external demand. To exacerbate the situation, the safe haven nature of JPY will cause it to rebound even more as it becomes evident that BOJ policy has failed and global growth risks rise.
As evidenced by the yen’s epic strengthening phase that began in 2007 – amid the same sort of global growth environment – the fate of Abenomics may once again end up outside of Japan’s control.