Yen’s Kamikaze Flight Trajectory

Forget about the flight to the dollar at the peak of the financialcrisis: the yen was the ultimate beneficiary. The endlessly quotedunwinding of the carry trade was a factor, but there may have been amore important force at play.

Forget about the flight to the dollar at the peak of the financialcrisis: the yen was the ultimate beneficiary. The endlessly quotedunwinding of the carry trade was a factor, but there may have been amore important force at play. As that force may now be under increasedpressure, the yen may be in trouble. The force we are talking about isthe free market.

How can market forces drive up the yen when Japanhas been a leader in quantitative easing, the “art” of printing money?Japan epitomizes the battle between market and government forces. Leftto its own powers, Japan’s economy would have imploded after its assetbubble burst in 1990. While painful, the good news about a deflationarycollapse is that you can rebuild; a collapse is also a brutal way ofweeding out those with too much debt. Instead, the government has, tovarying degrees, been fighting market forces ever since. However, as oflate, the Japanese have relaxed their attack on free market dynamics,in large part as a result of weak leadership.

Fightingmarket forces can be extremely expensive: if market forces ultimatelywin – i.e. the collapse ultimately happens – it’s possible for acountry to destroy its currency along the way. Left to market forces,those with debt likely go broke. Left to policy makers, everyone mayeventually go broke.

The yen started strengtheningin the summer of 2007. In September ’07, the prime minister at thetime, Shinzo Abe, resigned after months of mounting political pressure.Abe had succeeded the very charismatic Koizumi, who was featured invarious advertising campaigns throughout the U.S. promoting Japan.There have been three more prime ministers since Abe; there have beensix finance ministers in Japan since August of 2008. With such adysfunctional government, the government did not spend extraordinaryamounts, nor did the government interfere much with the Bank of Japan.Indeed, it seems almost ironic that the Bank of Japan, historicallyprolific quantitative easers, was conspicuously absent when the mostrecent round of global “quantitative easing contagion” infected centralbanks around the world. Left to market forces, consumers preferred tosave, bolstering the yen.

In that context, the conventional wisdom that a country needs to haveeconomic growth to have a strong currency is, in our assessment, wrong.Such a relationship only applies to countries that depend on foreignersto 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 priorityis to entice foreigners to keep financing U.S. deficits. Australia alsohas a current account deficitand, as a result, has a currency that is sensitive to economic growthprospects. Japan, however, traditionally finances its deficitsdomestically; as a result, the value of the yen is not very sensitiveto changes in growth forecasts. The same can be said for the euro zone:because the euro zone does not have a significant current accountdeficit, in our assessment, the euro can do well in the absence ofeconomic growth.

Another way to think about it is as follows: FedChairman Bernanke has repeatedly emphasized how going off the goldstandard during the 1930s allowed the U.S. to recover from the GreatDepression. In plain English: if you devalue your currency, take awaythe purchasing power of the people, you provide an incentive for topline economic growth. On the other hand, if you don’t pursue a policyto intentionally weaken your currency, you may end up with lousyeconomic growth on the backdrop of a much stronger currency. Japan andthe euro zone are prime candidates for that.

Except that the story may not have a happy ending in Japan. Japan’sability to finance its deficit domestically is limited and may run outin the coming years. At that point, Japan’s currency may be crushedgiven the weight of government debt. But rather than pondering aboutthe 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 inpower with barely any interruption since 1955. DPJ’s success was to agreat extent a reflection of the failure of the previous government;their party manifest was about cutting “wasteful” spending, but thenturning around to spend it on the “right” priorities. Known for fiscalconservatism and a hands-off approach to the Bank of Japan, 77-year-oldHirohisa 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 hardcurrency. What happened?

Aside from a couple of Japan-specific issues, such as shifting powerfrom bureaucrats to politicians, the new government has struggled tofind its course. As the realities of governing are setting in, theappointment of Kan as finance minister was the trigger for us tosuggest that the DPJ has gained focus. That focus suggests boostingeconomic growth through greater fiscal spending, a more interventionistapproach to managing the private sector; and greater meddling withcentral bank policy to boost economic growth. And, no, the Japanese arenot copying the U.S.; Japan is a leader in fiscal spending andquantitative easing; Japan had merely taken its eyes off the ball inthe past two and a half years. The focus is back on now – the yen mayhave been placed on a Kamikaze mission.

We are not suggesting the yen will fall off acliff tomorrow. Indeed, the yen’s risk-return profile may providevaluable diversification benefits to select portfolios. However, wehave stripped the yen of its hard currency status – a status the yenhad 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 investmentprocess is foremost driven by a quantitative model, supplemented by arisk and macro overlay; MABFX currently has neither a long, nor a shortposition in the yen. Currency exposures are subject to change withoutnotice.