我々は問題を抱えています - translates into: Tokyo we have a problem

The dominant theme in the currency market last week was the strong yen. What’s more, the upward movement in the yen flies in the face of the Bank of Japan’s NIRP (negative interest rate policy). When a central bank adopts NIRP, one of the effects should be a sharply weaker currency not a decisively stronger one.

This is a problem for Japan. A weak yen has been the key plank in “Abenomics” – Prime Minister Shinzo Abe’s turnaround plan for the Japanese economy. Japan has been plagued with deflation for over 30 years and a weaker yen is seen as the best hope. A weakening currency makes a nation's exports cheaper in other countries, and the theory is that expanding exports will boost the overall economy-- especially if that economy is stagnating or in recession.

This surge higher in the yen is leading to speculation about whether Japanese policymakers will intervene in the market. Intervention speculation is rooted in historical precedence because in previous similar situations the BOJ would aggressively intervene in the market by selling yen to weaken the currency.

However, it is unlikely that Japanese officials will directly intervene in the currency markets. They will most likely stick to verbal intervention with statements like “we are closely monitoring the currency”. The reason for this is twofold. Firstly, currency intervention is not very effective unless it is coordinated with other central banks. Secondly, intervention is frowned upon due to the consistent message from G7 and G20 meetings that countries should not seek a competitive advantage in the currency market. This is further complicated by the fact that Japan is hosting the next G-7 summit in May.

Yen strength is a real blow since it undermines the BOJ’s efforts to fight deflation. It also calls into question the credibility of not just the BOJ but that of all central bank in the market’s eyes. For instance, the euro had a simillar reaction to the last round of aggressive ECB policy action – it went up in the face of NIRP. The question being raised by the market is – what’s the point of continuing monetary polices of ZIRP, NIRP, and QE if a weaker currency is not achieved?

This type of talk is considered blasphemy to a central banker. We can be sure that the BOJ will promote an even more radical “whatever it takes” option to reflate the Japanese economy as soon as the next G7 meeting is out of the way – we can hardly wait.

Five and Counting

At the end of last week’s blog post, we mentioned that the central banks of Japan, New Zealand, and the USA would deliver policy announcements. We went on to say that no moves were expected by all three banks but if there was to be a move it would come from the Reserve Bank of New Zealand. On this count, we were half correct. There was a surprise move but it came from Japan not New Zealand, more on that later.

The big surprise of the week was the Bank of Japan adopting negative interest rates. The BOJ will charge 0.1% on any cash left on deposit with the bank. The yen responded with a loss of almost 2% on the week. This move shocked the markets because only a week ago Bank of Japan Governor, Haruhiko Kuroda, told an audience at the Davos World Economic Forum that he would not adopt negative interest rates. The bank’s policymakers, who voted 5-4 to approve the measure, took great pains to say the rate cut was based on global conditions and not the Japanese economy itself. It makes you wonder what the BOJ has seen that has changed their minds so quickly. It also makes you wonder why the Fed’s policymakers are not seeing the same thing.

The BOJ’s latest move makes it five and counting – i.e. five central banks that currently have a negative interest rate policy. The others are the ECB (-0.3%), Denmark (-0.65%), Switzerland (-0.75) and Sweden (-1.1%). We are emphasizing “and counting” because we believe that eventually other western central banks, including the US Fed, will have no choice but to adopt negative interest rates.

There were some changes in last Wednesday’s FOMC statement. The FOMC removed the line about the economy “expanding at a moderate pace” and replaced it with “growth slowed late last year”. They warned that market based measures of inflation compensation “declined further” and that inflation is expected to “remain low in the near term, in part because of further declines in energy prices.” The FOMC also explicitly said they were closely monitoring global economic and financial developments. These were nice dovish additions but we thought that the dropping of “risks being balanced” and the reference to being “reasonably confident” about inflation returning to 2% was more telling.

The changes to the FOMC statement reinforced what the market had already discounted – that the Fed's four rate hikes, as laid out in December’s dot-plot, are a fantasy. Before all the market turmoil in January, the fed funds futures were pricing in just two rate increases by year-end. The market is currently pricing in a single hike this year and traders see a 16% chance that the Fed will raise rates at its March meeting, down from 51 percent at the start of this year.

Looking ahead, it will be another busy week in the currency markets. The first trading week in February will see the release of Chinese PMI, UK PMI, RBA Rate Decision, German Labor Report, NZ Labor Report, BoE Rate Decision & Quarterly Report, US Non-Farm Payrolls, and the Canadian Employment Report.