The Tug of War over the Euro /Yen “Carry Trade”
“The fact that the Bank of Japan did not raised interest rates hardly surprises me,” said EU finance chief Jean Claude Juncker on March 20th, after the BoJ left its overnight call rate target at 0.50 percent. “I think that some people in Europe and elsewhere had got their hopes up after the recent interest rate rise. But we stick to the message that we sent at the G-7 meeting in Essen,” Juncker said.
“We think that Japanese growth is without doubt picking up. We think that the yen exchange rate (FXY) must reflect the fundamental facts of the Japanese economy. Our Japanese friends know that. And we are watching them,” Juncker warned.
Juncker’s opposition to a weaker yen was backed up by European Central Bank chief Jean “Tricky” Trichet who spoke before the EU Parliament on March 21st. “I have signed the G-7 communique, a very important text, signed by the Americans, the Japanese, the Europeans, and we have all said we are going to continue to keep a very close eye on exchange markets and cooperate as necessary,” he said.
After watching the Japanese yen sink by roughly 65% against the Euro (FXE) over the past five years, European finance and trade officials are alarmed by Tokyo’s “cheap yen” policy, and want the Bank of Japan to raise its interest rates to shore-up the value of the yen. Japan’s near-zero interest rates and severely undervalued currency are at the root of the estimated 40-trillion ($440 billion) “yen carry” trade, and massive distortions in global bond and stock markets.
Tokyo’s ruling elite did capitulate to heavy European pressure at Essen on Feb 10th, and agreed to a quarter-point BoJ rate hike to 0.50% on Feb 21st, the second increase in five years. But it’s hard to get Tokyo to wean itself off low interest rates. “For now, the BOJ will maintain easy monetary conditions, while monitoring economic and price conditions,” BoJ chief Fukui told parliament on March 26th.
“The BOJ and the government will work closely. They have to sustain the Japanese economy and get it out of deflation. The price movement is still weak and this is a challenge for the BOJ,” said Japan’s powerful FX chief Hiroshi Watanabe on March 16th. But European finance ministers know that Japan’s low inflation figures are fraudulent, and are not buying Tokyo’s deception any longer.
Japanese exports to the European Union have doubled over the past five years to 1.04 trillion yen in February, while European exports to Japan fell 8% during the same time period. But if the Euro’s appreciation against the Chinese yuan and Japanese yen is left unchecked, European exporters could suffer in world markets from price handicaps with Japan and cut-throat competition with China.
The clash over the volatile “Euro /yen” carry trade between European and Japanese monetary officials is likely to escalate, with the ECB telegraphing a quarter-point rate hike to 4.00% in the months ahead to counter its exploding M3 money supply, while Japan’s FX chief Watanabe is pressuring the BoJ to keep its powder dry. Speculation of a unilateral ECB rate hike, not matched by the BoJ, is behind the Euro’s strong rebound from 151-yen on March 5th to as high as 157.5-yen on March 26th.
The Euro zone needs a strong Euro /US$ to shield against higher import prices for industrial commodities in the months ahead. “Central banks have to react appropriately to high oil prices pushing up inflation in oil-importing nations, and stop these increases feeding into consumer prices and wages. They must be ready to tighten the monetary reins as soon as significant risks of second-round effects appear,” said Spanish central banker Jose Manuel Gonzalez-Paramo on March 16th.
“We see certain clouds on the horizon for the end of the year and for 2008 concerning inflationary developments,” said Austrian central banker Klaus Liebscher on March 27th. “So altogether, I think we are not well advised to be too complacent. A very close monitoring of the situation is important, and we will decide what is necessary to keep inflationary expectations under control,” Liebscher added. (That’s an awful lot of “jawboning”, for a baby-step quarter-point rate hike!)
But Japan’s economy was sizzling at a 5.5% annualized rate in the fourth quarter, and the “jawboning” signals from Japanese finance officials can change at a moment’s notice, to guide the Euro /yen into the secret trading range agreed upon in Essen, Germany on February 10th. BoJ chief Fukui hinted at a third rate hike to 0.75%, in his speech on March 26th, “We will adjust interest rates gradually based on economic and price conditions,” he told a parliamentary committee.
“When the economy is recovering or expanding, albeit gradually, there could be side effects if market expectations lean too much towards the view that interest rates will be kept low for too long,” Fukui added. Most interesting, is how small shifts in interest rate differentials of just 10 or 15 basis points between the Euro and yen, can lead to such violent swings in the cross rate between the two currencies.
And at least for now, the direction of the Euro/yen exchange rate has become a key driver of the EuroStoxx-600 (FEZ). Europe’s top blue chips have been heavily pumped up with Japanese steroids, or cheap-yen margin loans, and have displayed an 88% degree of correlation with the Euro /yen so far this year. Merger and takeover deals worth $311 billion involving European targets have also been announced, just slightly below the record levels in Q’1 of 2006, and buoying equities.
On March 15th, Bundesbank chief Axel Weber warned against the practice of trading European stocks with money borrowed in yen, “The recent correction is a warning that carelessness and under-pricing of risks are not advisable even in a very favorable financial market environment. An unexpected deterioration in the macroeconomic environment could trigger a turnaround in sentiment with widespread repercussions. It is therefore essential that risks are taken into account and priced appropriately,” he warned, but few traders are listening.
Bank of Japan is the Biggest Player in “Yen Carry” Trade
European finance ministers are finding it difficult to combat the market’s addiction to the “yen carry” trade, since the world’s biggest addict is the Bank of Japan itself. Tokyo’s ministry of finance controls $884 billion of foreign exchange reserves, which are mostly held in US dollars. The MoF borrows yen in Tokyo by selling short-term government paper, and then buys US dollars in the currency market.
The MOF’s is paying an interest rate of 0.58% on its intervention financing bills, while earning a 5.05% return in three-month US Treasury bills. As a result, Japan earned about 3-trillion yen in interest income last year, far outstripping its interest expense of 460.6 billion yen. But if the BoJ is forced to raise short-term interest rates to placate Europe, the MoF’s interest expense could rise to 1.16 trillion yen in fiscal 2007/08. The spread would get squeezed further, if the Fed lowers US$ rates.
Acknowledging that most of Japan’s official reserves are in US dollars, Finance chief Koji Omi told a parliamentary committee on March 23rd, “We have no plan to substantially change the composition.” But some Japanese lawmakers say the government’s $884 billion intervention fund could be used to help pay down some of Japan’s $6.7 trillion national debt, equaling 155% of GDP. Japan is projected to incur $177 billion in interest expense on the debt in the fiscal year ending March 31st.
The possible unwinding of the “yen carry” trade has made European stock markets skittish, but what other powder-keg that could ignite in the future, and trigger another big Euro-Stoxx Index shake-out? Which markets are most impacted by the Shanghai bubble? Which foreign stock market is the first to telegraph the next likely move for the global stock markets?
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