What happens to the Euro If the Yen Keeps Falling?

April 11, 2013

The Kuroda revolution in Japanese monetary policy is a huge and extremely rare event that reminds me somewhat of October 1979 when the Federal Reserve changed the operative target of its money market operations to nonborrowed reserves.  This might seem an odd comparison since the Fed was trying to tame runaway inflation and the Bank of Japan is attempting to end over a decade of deflation.  The similarity lies in a shift of policy approach with extremely profound implications. 

In each instance, policy was overhauled not only in degree but also in kind.  Fed Chairman Volcker created an element of automaticity that enabled politically unpopular decisions and made the potential rise of market interest rates virtually limitless.  Kuroda likewise shifted the operative guide from an interest rate to growth in the monetary base and central bank balance sheet.  Each change was made after years of policy futility that had conditioned market participants to expect only verbal sound and fury from these central banks but nothing truly significant

I was comparatively new to the Chemical Bank Foreign Exchange Advisory Service when the Fed decision came down.  At a full staff meeting to discuss how the market outlook had changed, there was a lot of resistance to taking a bullish stand on the dollar, given its chronic propensity to disappoint throughout the 1970s.  But one of our London people cut to the chase, urging the others not to get bogged down in details and to grasp the reality that a sea-change was happening.  The Fed’s “punk monetarism” as he called it changed everything, even if one doubted the teachings of monetart theory.  The dollar was trading at DEM 1.76 at the time, and he predicted that DEM 2.50 would be a minimum objective.  The U.S. currency would eventually reach DEM 3.47 in February 1985, by which time a secular downtrend in inflation had become established, and that process of disinflation is still broadly continuing.

Governor Kuroda’s ability to line up near unanimous support within the Bank of Japan for the enormously aggressive stimulus earns a vote of confidence that he is not going to fail for lack of effort.  One can imagine reasons why the yen might not fall much further such as international pressure against perceived competitive currency depreciation.  But the simplest assumption to make at this juncture is that these are still early days of what could be a big additional rise in dollar/yen.  For years, 120 per yen was a dollar ceiling.  The dollar first approached 120 at the end of 1987 but it would take until 1995 for that level to be convincingly smashed.  It may be that coming from a position of prolonged yen strength that 120 will again take on chart-point significance, only this time as a yen floor.

What then is likely to happen to the euro against both the dollar and yen?  The European common currency already has risen from 2012 lows of $1.2041 and JPY 94.07 to highs today of $1.3139  and JPY 131.15, respective gains of 9.1% and 39.4%.  While the advance against the dollar has been only moderate, the euro has already accrued a rather extensive move against the yen.  One has to wonder how much more of a swing in the same direction the market will bear.  In theory, nonetheless, good theoretical reasons exist for expecting the euro to climb certainly against the yen but also versus the dollar.  One idea that’s circulating in the market is that the yen is now an ideally suited liability currency (the one that’s borrowed at low cost) for carry trade investments.  Also, diversification remains a long-term force, and the direction of such activity is from the dollar with its heaviest weight in asset portfolios to the euro.

When all is said and done given the uncharted nature of global financial markets, shedding light on possible behavior of the euro if the yen keeps falling against the dollar is foremost an empirical exercise.  How did the euro behave when the yen fell in previous episodes?   And to get more observations, one also should examine how the euro’s closest ancestor, the D-mark, behaved at such times prior to the euro’s birth in 1999.  Here are my findings.

  • From October 31, 1978 to April 1980, the yen dropped 33.0% against the dollar, and the mark lost 13.9%.
  • From January 22, 1981 to August 1981 turning points, the yen fell 19.0% against the dollar, while the mark lost 21.6%.
  • From December 1, 1981 to November 5, 1982, the yen declined 23.2% against the dollar, and the mark slumped 13.9%.
  • From December 5, 1988 until June 15, 1989, the yen lost 19.5%, and the mark fell 15.6% versus the dollar.
  • From August 17, 1983 to December 30, 1993, the yen dropped by 9.4% and the mark lost 5.6% against the dollar.
  • From April 19, 1995 to May 1, 1997, the yen plunged 37.2% against the dollar, and the mark slumped 21.0%.
  • In the Asian crisis, the yen fell 23.5% against the dollar between July 7, 1997 and August 11, 1998, while the D-mark slipped just 1.9%.
  • Between December 31, 2004 and June 22, 2007, the yen fell by 17.3% against the dollar as the euro edged down only 1.0%.

And now for some conclusions.  First, in none of the above instances of significant yen loss did Europe’s main currency record a rise against the dollar.  Second, in just one instance did the mark’s or euro’s move downward exceed the yen’s.  Third, the more recent examples had greater differentiation between the behavior of dollar/yen and dollar/mark or EUR/USD. 

A wild card in all this speculation is the hypothetical possibility of another transforming event.  Such a possibility is not remote.  Stocks, bonds, or both could with hindsight prove to be asset bubbles waiting to blow apart.  A multilateral currency war could erupt. The European Monetary System could break apart, or the U.S. government could default on its debt.  North Korea might bomb Seoul, Tokyo, or the U.S. Pacific Northwest.  Iran could bomb Israel.  And from the ridiculous to the more sublime, the Bank of Japan could get cold feet, water down its stimulus plans, or abort them too soon.  It so happens that the dollar’s post-1979 transformation was delayed by the interference of credit controls in the first half of 1980, which separated the U.S. recession into two parts.  The first installment was too short to conquer inflation.  It took a second recession from mid-1981 until late 1982 to get the job done. 

Finally, what about the observation that the euro already has climbed nearly 40% against the euro?  I wouldn’t take much comfort from that.  The 40 years of dollar floating have seen instances when key currency relationships have swung 100%, such as the mark’s slide from 1.703 per dollar in late October 1978 to 3.47 in February 1985 and its subsequent reversal to 1.576 by the end of 1987.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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