Investors must get used to a weaker yen

Now the commotion of a snap election is over let's get down to the root problems of the currency.

Forget sterling, this is not the UK and the pound.

Let's talk about the yen now that all the noise following Shinzo Abe's election victory has died down.

In the weeks leading up to the election, the yen strengthened - a reaction that wouldn't surprise regular Japanese investors as the currency attracts so-called "haven flows" during times of uncertainty.

Haven currency

The yen's haven status reached its peak in the three years following the 2008 financial crisis, and was a regular store of value thanks to haven flows.

And this is thanks to a combination of its use as a funding currency in carry trades and its large net foreign asset position.

Because of its historically low interest rates, Japan's yen has often been used in carry trades - where a low yielding currency is used to buy higher yielding assets to benefit from the yield differentials.

In times of market volatility, these trades would be quickly unwound, leaving large yen positions.

Secondly, in times of geopolitical tensions, Japanese investors would repatriate their large holdings of foreign assets back into yen.

Thus, the currency built up a history of safety in times of turmoil - strengthening throughout the financial crisis and hitting its record high against the dollar at Y75.95 at the heart of the eurozone debt crisis in 2011.

The yen today

Although a long way off these levels now, the yen isn't particularly weak by historical standards. But measured in the timeframe of the last six years, it certainly is.

The "arrows" of Abe have not yet been successful in tackling weak inflation: Wikimedia Commons

And it is this weakness that Japanese authorities hope will drag the country out of decades of low inflation and limp growth.

"In the wake of the election result, we expect Abe to pursue his bold monetary policy, the so-called ‘’First Arrow’’ of Abenomics, and retain the 2% inflation target," says Katsunori Kitakura, lead strategist at SuMi Trust.

"Looking forward, the widening interest rate gap between Japan and the US, and the ensuing weak yen will enable companies to keep growing. This growth will be further supported by the current global economic expansion and the Bank of Japan’s continued monetary easing."

Economic recovery

Japan's economy is not showing too many signs of frailty. Second-quarter gross domestic product grew at 0.6% quarter on quarter - its sixth-consecutive quarter of growth.

But it was some way below expectations of 1%, and the annual growth rate of 2.5% was expected to be much closer to 4%

The latest PMI data have shown a slight decline in manufacturing, but input prices are rising at a fast clip - and this is likely down to the weaker yen.

Meanwhile the third-quarter Tankan report that assesses conditions at Japanese businesses was impressive.

Viraj Patel, foreign exchange strategist at ING, says: "Japan’s strong Tankan report, with big gains for large manufacturers and gains in most of the other indices, including profits, suggest that the momentum behind Japan’s economy is still strong and that the Japanese economy can withstand a stronger yen."

A stronger yen?

Indeed, should economic growth start to strengthen more rapidly and rising input prices start to feed into consumer inflation, then the yen should start to receive a significant boost.

But that has been said by many before, and still inflation refuses to take a hold in Japan.

BoJ governor Kuroda may be forced to lower the Bank's lofty inflation forecasts: Wikimedia Commons

"We continue to forecast above-consensus growth this year and next, but very low inflation," say analysts at Capital Economics.

"Indeed, the Bank of Japan will probably be forced to lower its lofty inflation forecasts further at its meeting at the end of October. This means that monetary policy tightening is still a long way off. With the consensus coming around to this view, we expect the yen to weaken only slightly in coming months."

The most likely thing to contribute to a stronger yen in the coming months, then, appears to be haven flows  ue to further geopolitical tensions.

David Kohl, chief currency economist, Julius Baer: "The geopolitical risk arising from North Korea sabre-rattling remains the main argument not to be overly negative for the yen outlook. The currency tends to profit as a safe haven from rising geopolitical risks."

Jane Foley at Rabobank agrees: "In recent months it has been the newsflow from North Korea which has probably had more influence on the value of the yen that any other single factor. 

"That said, the policies of the BoJ have had a significant impact in ensuring that the value of the yen has remained soft when judged from an historical perspective."

Bank of Japan

So, is the yen likely to strengthen significantly in the near term? Unless haven flows become overwhelming, no.

The Bank of Japan is nowhere near dialling back its massive stimulus programme, and while the BoJ remains in its current ultra-easing mode, the yen has no yield benefit over any other major currency.

"The strength of the yen is not only a key driver of corporate profitability, but also of sentiment towards Japanese assets more generally and the BoJ’s current monetary policy framework will ensure that this will continue to be determined by external factors in the near term," says Daniel Minett, investment director at Brooks Macdonald.

If, however, Abe succeeds in persuading companies to use their large cash piles to raise wages and pushing through other fiscal reforms, the economy will grow and the yen will appreciate.

But for the time being, Abe, the BoJ and corporate Japan appear comfortable with a weaker yen.