Why a global trade war might confound investors’ flight to the Japanese yen for safety
David Brown says given the state of the Japanese economy and trade war fears, the yen is not necessarily a safe haven for investors
When the going gets tough, it always helps to have a friend to lean on to carry you through. Investors soon learn who their friends are and who they can cling to until the storm blows over. In the past, the Swiss franc, Japanese yen, German government bonds and gold have all earned strong reputations as safe haven bolt-holes when financial markets have been in meltdown and the outlook for risk-taking has been in doubt. A friend in need is a friend indeed, as the saying goes.
The past decade might have put investors through the wringer, but the depths of the 2008 crash, Europe’s debt crisis and numerous other upsets have been made easier by the guardian angels of the safe haven trade. The worry now that the global economy is returning to normal is how to navigate the choppy waters of recovery with new squalls on the way. With the world staring into the jaws of a full-blown trade war, it may be time for investors to size up their safe haven bets.
The yen has always been seen as a favoured fallback option for investors during unsettled times largely because its price behaviour seems remarkably rule-based. In an age of algorithmic trading, investors see the yen as a good contingency, conforming to predictable behaviour patterns. At the darkest point of the 2008 crash, investors flooded into US dollars in a general flight to quality, but the yen became the cachet for safety as the dollar fell from grace in subsequent years.
The ironclad rule when market risk goes up is that the yen generally rallies. And when volatility eases, the yen invariably sells off. It is so simple that it is no wonder hedge funds and prop traders love it. But this has less to do with the yen’s true fundamental merit than with the ebbs and flows of Japanese investors flooding in and out of the currency as good and bad times roll. For savvy investors, the yen is not so much a bellwether for global market stability, but more a proxy for how Japanese funds feel about the state of investing abroad.
Japanese investor flows are so great they have a dramatic whipsaw effect on the yen. Outward investment flows have been the consequence of the Bank of Japan’s monetary stimulus limiting rates of return in the home market, forcing investors into higher-yielding investments abroad like emerging markets. At the first hint of trouble, Japanese investors beat a hasty retreat back home, to avoid the double whammy of both capital and currency losses incurred.
It is a knee-jerk reaction that international investors mimic as a safe haven hedge. Based on Japan’s economic fundamentals, it is a misnomer. Japan may be the world’s wealthiest creditor nation, with huge financial wealth amassed abroad, but domestic fundamentals leave much to be desired.
Japan remains in poor fiscal shape with a gaping black hole in its public sector finances. It runs the biggest debt to gross domestic product ratio among Organisation for Economic Co-operation and Development (OECD) countries, worth up to 225 per cent of GDP.
Japan’s economy has been stuck in a deflationary slump for decades, leaving the monetary authorities little chance of normalising interest rate policy for a very long while. In fact, short-term interest rates in Japan could be stuck at zero for many years to come.
“Abenomics”, the government’s three-pronged strategy for boosting money supply, pumping extra fiscal stimulus and promoting more structural reforms, seems to have lost its way, with growth momentum fading again. As a major exporter, the threat of a global trade war could hit both Japan and the yen very hard.
Trying to fathom what it means for the yen is tricky. In the coming months, the yen is stuck between three conflicting forces – conviction that Japan’s recovery prevails, confidence that global stability is maintained, combined with a need to play safe. Until the logjam breaks, yen depreciation trades will dominate thanks to the widening US-Japan interest rate gap as the Federal Reserve keeps tightening the monetary knot. On relative yield appeal, the yen is on a hiding to nothing.
Betting on a stronger yen right now is taking a gamble that global risks have reached breaking point. In the thick of a global trade war, the jury is out on a stronger yen as Japan’s recovery stays in peril.
David Brown is chief executive of New View Economics