A currency war is coming

This article first appeared in The Edge Financial Daily, on March 8, 2018.
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AS if a brewing trade war was not enough to worry about, investors also need to be alert to the threat of a major currency conflict.

Norihiro Takahashi, president of Japan’s Government Pension Investment Fund (GPIF), dismissed US President Donald Trump’s tariffs plan as a “performance” for his supporters, and said US assets are no longer expensive, in an interview with The Wall Street Journal this week. That marks a change in stance since the December quarter, when the world’s largest pension fund scaled back its exposure to foreign assets.

Takahashi’s comments could well be a veiled expression of Japan’s displeasure at a stronger yen. The Japanese currency has soared 6.6% against the greenback this year — and we are only three months into 2018. For a yen-based investor, Treasuries, in particular, do indeed look more reasonably priced than in December (see chart — Kuroda’s Headache).

In theory, currency policy falls under the jurisdiction of Japan’s finance ministry. In practice, government agencies from the Bank of Japan (BoJ) to the GPIF co-ordinate their actions. Do not forget that on Oct 31, 2014, the central bank expanded its monetary policy on the same day the GPIF adopted a “new policy asset mix” that increased the fund’s exposure to foreign bonds.

BoJ governor Haruhiko Kuroda can deny it, but the central bank has every interest in seeking a weak yen. Japanese corporate earnings are highly cyclical: On a market-weighted basis, companies on the Topix index derive more than 37% of their revenue from abroad, data compiled by Bloomberg show. A strengthening yen can cause stocks to plunge, depressing consumption and tipping the economy back into deflation.

With the Topix down more than 10% from its January high, that is no idle threat. The Consumer Price Index ex-food, the BoJ’s inflation metric, was 0.9% in January, still nowhere near the 2% target that was last breached in 2015. Kuroda’s domestic toolbox, meanwhile, is starting to look empty. With a record 40% of government bonds already in its hands, the central bank is running out of assets to buy.

Desperate times call for desperate measures. From Japan’s point of view, the greenback is frustratingly weak, even as new US Federal Reserve chairman Jerome Powell prepares to raise interest rates at least three times this year. US bond yields have become divorced from the currency. In theory, a higher interest-rate differential — Japan has pledged to keep its 10-year yield at zero per cent — should lead to a stronger dollar. In practice, it has gone the other way.

The problem, as I have written, is Trump’s fiscal imprudence. After his tax cuts, the US budget deficit is forecast to widen further. And given the president’s sabre-rattling on trade, it is not hard to conclude that he wants the dollar to depreciate.

The GPIF president’s remarks add intrigue to an idea floated in late February. The central bank can keep the yen weak by buying US government bonds as “a means for delivering proper monetary policy for Japan,” Koichi Hamada, an economic adviser to Prime Minister Shinzo Abe, told Reuters.

Currently, markets are latching onto Kuroda’s March 2 remark that the BoJ will start thinking about how to exit its monetary easing programme around the fiscal year starting in April. If an exit was ever contemplated, Trump’s trade talk may have changed the calculation.

Kuroda is an innovative man and has surprised markets in the past. With the central bank meeting again today and tomorrow, do not rule out another shock. — Bloomberg