Surging yen reveals limits of central bank policy action

For some time now, financial markets have been determining the conduct of monetary policy.

Investor sentiment has become the tail that is wagging the central bank dog.

For the US Federal Reserve, the strong influence of markets on monetary policy, although concerning, has proved beneficial.

Bond markets have been acting as an “important automatic stabiliser” for the economy, Fed chairwoman Janet Yellen admitted in a dovish speech on March 30, with “changes in market expectations about the likely path of policy resulting in movements in bond yields that act to buffer the economy from shocks”.

This buffer has manifested itself partly in global foreign exchange markets, with the US dollar index – a gauge of the greenback’s performance against a basket of its peers – down nearly 4 per cent in just the past month, easing the strain on the ailing US manufacturing sector and making it more likely that the Fed will be able to continue to raise interest rates later this year.

For the Bank of Japan, however, currency markets have become an enemy of the central bank.

While the yen plunged nearly 60 per cent against the US dollar between October 2012 and June 2015 as the Bank of Japan pursued its aggressive programme of quantitative easing (QE) and investors anticipated a tightening in US monetary policy, Japan’s currency has strengthened 9 per cent since its central bank surprised markets on January 29 by introducing negative interest rates.

The yen’s status as a “safe haven” currency was already reasserting itself in the second half of last year when fears about mainland China’s economy intensified. However the sharper appreciation of the yen over the past two months has taken its toll on corporate confidence.

On April 1, the publication of the Bank of Japan’s latest tankan survey showed a dramatic deterioration in conditions in Japan’s manufacturing sector, with the worst reading since June 2013, only months after Japanese Prime Minister Shinzo Abe’s reflationary programme, dubbed “Abenomics”, got under way.

Just as worryingly for the Bank of Japan, companies are less and less confident that the central bank will hit its 2 per cent inflation target by 2021, reflecting weak corporate investment and mounting concern about the sharp reversal of the yen’s depreciation – arguably the most important plank of Abenomics.

Not only does this throw the failure of the Bank of Japan’s negative interest rate policy into sharp relief, it heaps further pressure on the central bank to provide yet more stimulus at its next policy meeting on April 27-28.

On Wednesday, the yen rose to its strongest level against the US dollar since October 2014 when the Bank of Japan expanded its QE programme. Not surprisingly, the export-sensitive Nikkei 225, Japan’s main stock market index, is down more than 8 per cent since March 28 (and more than 20 per cent since the end of November), one of its longest losing streaks since Abenomics got under way.

The yen’s surge in the face of aggressive monetary stimulus from the Bank of Japan also shows the waning influence of central banks’ policies.

The Bank of Japan and the European Central Bank (ECB), which have both sought weaker currencies to boost inflation and growth, are now grappling with exchange rates that are rapidly moving in a growth-unfriendly direction.

This lends weight to the conspiracy theory promulgated by a growing number of investment strategists and currency traders: a decision was taken at the G20 meeting of finance ministers and central bankers in Shanghai in late February to stabilise currency markets through a depreciation of the US dollar. While the ECB and the Bank of Japan will place less emphasis on negative interest rates (which are partly designed to weaken the euro and yen), the Fed will tighten monetary policy at an even more gradual pace than originally envisaged, resulting in a weaker US dollar and easing pressure on China to devalue the yuan further.

While there may be some truth to the current chatter in currency markets – the ECB said last month that it does not intend to cut rates further for the time being while the Fed has struck a distinctly more dovish tone in recent weeks – there are limits to how far the yen and the euro can be allowed to rise against the US dollar.

If Japan’s currency strengthens further, the Bank of Japan will come under intense pressure to intervene in the currency markets in order to drive down the yen.

The problem is that currency investors doubt the Bank of Japan’s resolve and are increasingly convinced the US dollar will weaken further.

Abenomics, already deemed a failure by many market commentators, is in serious trouble.

Nicholas Spiro is a partner at Lauressa Advisory