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30 August 2010

FX Update: Bernanke effect vanishing quickly

John J. Hardy, FX Consultant, Saxo Bank

Friday's reaction to the Jackson Hole speech has proven ephemeral so far, as JPY crosses reversed back lower after the small squeeze on JPY positions ended after the BoJ meeting. What now?

JPY rally

After last week's bludgeoning of the JPY on intervention rumors and then the coming and going of Bernanke's speech Friday, the JPY rallied very sharply from new lows in Asia after the BoJ meeting. The Bank did expand a bank-loan program and added a 10 trillion JPY in liquidity into the banking system, but this was not considered a decisive response relative to the magnitude of JPY appreciation of late and the speculation generated by a recent emergency meeting between administration officials and the Bank of Japan. This bolsters the view of those who believe that the BoJ can or will do little to actually intervene here and will try to bide its time until the pain is far greater. The sharp comeback in the bond market after Friday's sharp consolidation, especially in Europe, was an added reason for the JPY's comeback into today's session. Still, we shouldn't perhaps give up on the potential for a strong response from the Japanese government as cabinet ministers are holding an emergency meeting today to determine the impact of the JPY strength at these levels on the economy and what could potentially be done about it.

According to an article from Bloomberg, Deutsche bank estimates that the 1995 low in USDJPY (at just below 80) would be the equivalent of 55 today, while a more conservative estimate from Westpac suggests that it is more like 75. Regardless, that's a long way off. Another way to estimate how low the rate can go is to estimate what the rate would be should the spread on bond yields at the long end of the Japanese/US yield curves go to zero (and very importantly, do so without a significant divergence in sovereign default risk) since the USDJPY rate is so often bound up with this spread. See the chart below.

Chart: USDJPY and long bond yields

If we take the 10-year yield spread as a basic benchmark rate for judging the relative value of USDJPY, we see tha the response of USDJPY to yield spreads has weakened a bit , though it is still directionally very important.(We've done this in the past for the 2-year yield spread, but that is rapidly approaching zero and the Fed is doing what it can to monetize debt to keep long yields low as well.) At present, the spread is almost 170 bps, down about 90 bps from the recent high just under 260 bps. During that time, USDJPY fell as much as 10 big figures (94 area to as low as the 84 area), so another 170 bps would equate to 15-20 more big figures of JPY strength vs. the USD. This assumes, of course, that all out deflation takes hold in the US and the market continues to bid up US treasuries to Japanesque levels and that the Japanese economy doesn't collapse on a China derailment, etc.... but interesting to ponder this, nonetheless. Of course, this also assumes that the relationship of yield spreads and the USDJPY rate remains linear - which it has not been at times over the last year. The 2-year spread is far "better behaved" and that spread has flattened out in recent weeks.