Two Days After Japan’s Intervention: What Now in Foreign Exchange?

September 17, 2010

Japan’s intervention on September 15 broke several rules.  The operation was taken against the wishes of Japan’s allies in Europe, Asia and North America.  Japan has deflation, but other economies have lower-than-desired inflation and price trends that continue to slow.  All governments would like a softer exchange rate but know that is an impossibility.  So G-7 leaders have repeatedly agreed that flexible, market-determined exchange rates are best.  If markets have failed to deliver optimizing currency values in the shared opinion of several governments, then and only then should intervention be used and conducted in a joint, rather than unilateral, manner.  In Japan’s present circumstances of a chronically big current account surplus not offset by sufficiently disadvantageous interest rate differentials, a rising yen makes fundamental economic sense. Because Japan has experienced deflation while prices rose in other countries, the yen against the dollar or versus a trade-weighted index is now considerably more competitive than the last time it traded near 80/USD in 1995.  Japanese officials have not provided other macroeconomic forms of stimulus before turning to the intervention option.  The Bank of Japan has resisted more forceful types of quantitative easing advocated by its critics, for instance, and incremental fiscal stimulus has been relatively moderate.

The market reaction to Wednesday’s intervention was not terribly impressive by past standards.  In a country with a tradition of battering ram-like heavy intervention prior to March 2004, no day had ever seen Japanese officials sell a greater volume of yen than what they did two days ago.  The dollar’s maximum rise so far against the yen of 3.3% from 82.87 to 85.63 is smaller than the euro’s 3.6% rise from $1.2706 to $1.3161.  When Swiss officials launched an inflation campaign in early 2009, the franc advanced 5.9% against the euro between March 6 and March 17.  When the Carter administration activated a rescue of the dollar in late 1978 with a program that included significant intervention, the dollar gained 11.9% from DEM 1.7030 on November 1 to DEM 1.9065 on November 6.  After Group of Five finance ministers presented an accord with a commitment to weaken the dollar through intervention and supporting macroeconomic policy changes, the mark climbed 10.4% from 2.9145 per dollar on September 19, 1985 to 2.6405 on October 3, 1985.  And in the maiden year of flexible dollar rates, the U.S. currency fell in a purely free float from DEM 2.90 in early March 1973 to around DEM 2.20 four months later, but following a U.S. Treasury decision to utilize foreign exchange intervention on a discretionary basis, the dollar recouped all of its lost ground in the second half of 1973.  Private-sector currency trading was infinitely smaller in those nascent days, giving intervention much more leverage as a policy tool. 

G-7 officials have repeatedly said intervention mustn’t be utilized to achieve a particular currency value but rather to counter market volatility  characterized by disorderly intra-day movements with wide bid-asked spreads and a lack of market breath, depth and resiliency.  The prior appreciation of the yen this year had been very orderly, making Japan’s intervention at this time not a textbook example of when intervention should be employed.  During the first half of 2010, the yen had advanced 5.2% against the dollar or less than 1% per month.  The yen had risen by a further 6.7% (12.3% in all from end-2009) when Japanese officials decided to act on Wednesday.  The disorderly market argument has been used to put pressure on Chinese officials to adopt a more flexible policy toward the yuan.  Japan’s actions place such criticism of Chinese policy in a duplicitous light.

The operation on Wednesday had two elements that should have made the yen move more sharply.  Investors for one thing were clearly surprised, since officials acted near the yen’s 15-year high of 82.87 per dollar.  Also, Tokyo officials took the unusual step of saying that whatever yen is sold will be left in the money market.  In economist jargon, this is to be unsterilized intervention, the good kind and an effective tool to grow Japan’s money supply.  Such has expanded just 2.0% per annum since 2000 in contrast to a rise of 10.9% per annum in 1988-90 before the country’s financial crisis. 

It is rumored that officials in Japan want to see the yen weaken to 90-something per dollar.  Intervention tends to lose effectiveness over time unless 1) economic fundamentals change in a way that supports the desired movement of the currency, 2) other macroeconomic policies change sufficiently and continue to get modified, or 3) recourse to intervention is postponed until a truly misaligned level is reached, imposed by purely speculative transactions and not consistent with economic fundamentals.  None of these caveats seems appropriate in the yen’s present case, which is why market chatter has been so dismissive of the initiative.  All of this logic makes more sense from a medium-term than short-term perspective.  These operations involve the sale of Japan’s own currency.  If officials are willing to subordinate all other policy priorities, which Japan’s are not, there is no excuse for an inability to debase one’s own currency.

When one takes a broader perspective of the entire currency trading landscape, it’s difficult to get excited about the euro, dollar, or yen.  Europe’s sovereign debt crisis crescendoed just four months ago and continues to smolder as attested by the continuing wide bond premiums of the peripheral EMU members.  European growth has been very uneven, and the best recovery months are behind including for Germany.  The U.S. situation is even more disturbing if only because the United States has far more to lose than Europe, having enjoyed economic and financial market supremacy since the late 1940s and unchallenged geopolitical superpower status for the last twenty years. 

The main event of the coming week is the FOMC meeting and whether quantitative easing is enacted.  If so, the euro probably will end up in the $1.30s against the euro, but a return decline into the $1.20s if Fed officials decide instead to merely wait and see how developments continue to evolve.  The Swiss franc also bears watching.  Prior to Tokyo’s surprise policy move, the Swissy crossed unity briefly to reach 0.9932 per dollar.  The Swiss National Bank lost quite a bit of money in fruitless intervention to cap the currency’s strength and will not return to that strategy even if unity is passed.  Instead, officials have signaled a lower and more extended path of rate normalization in Switzerland.  If the dollar slides against the euro, there’s nothing sacrosanct about the 1:1 USD/CHF level, and it will get crossed again.  Otherwise, the franc ought to hold on the weak side of that key level.

The British economy is the world’s canary.  If fiscal restraint sends anyone into a double-dip recession, it will be there because Britain’s government is subjecting the economy to stiffer and more front-loaded medicine than other advanced economies.  Until and unless economic activity tanks in the U.K., sterling will be supported by relative high inflation that constrains the Bank of England’s options for ease. 

The Australian and New Zealand dollars are moving further above USD 0.9000 and USD 0.7000, respectively, and the reason is firmer commodity prices and the global optimism that’s been also reflected in higher long-term bond yields and rising equities.  Such optimism is fleeting and contrary to most private and public forecasts that show weaker economic growth by 2011 in a number of countries.  The Aussie dollar touched a 2010 high today of USD 0.9472.  It’s not far from joining the Canadian and Swiss currencies in trading close to unity.  For them, the technical trappings of that mother of all psychological levels should not be taken lightly.  It’s a fact that intervention support and a sharp series of interest rate increases by the Bank of England in early 1985 explicitly to prevent sterling from sinking to and below par against the dollar was a principal catalyst in ending a five-year-long general dollar uptrend against many currencies.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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