As if to confirm the Asian region’s economic strength, Japan’s economy grew by an annualised 2% over Q3, confirming the country’s longest unbroken period of economic expansion since World War 2. Not only was the Q3 2006 outturn stronger than expected, but it built on an upwardly revised 1.5% for Q2 (previously 1.0%). Not only does the data leave Japan on track for 2.5% growth over 2006 and 2007 but, perhaps more importantly, it leaves the way clear, despite some political opposition, for the Bank of Japan to raise the Official Discount Rate (Base Rate) from just 0.25% (itself a hike from 0.0 on 14th July this year) on December 18th-19th, in the wake of the quarterly Tankan Survey. Given that recent comments from the Bank of Japan governor, Toshihiko Fukui, indicate that base rates at prevailing levels are unsustainable there had been some discussion about the possibility of an even earlier rate hike. The significance of all this lies in the possibility that Japanese base rates have much further to rise than the markets are currently pricing in. The question is whether the economy is robust enough to sustain base rates of c 2.5% and what might happen to the much vaunted “carry trade” were rates to reach those levels.
Japanese interest rates: what a rate hike would mean for the Yen
Drilling into the data it appears that both business investment and exports added a handy 0.4% each to the economy’s overall performance. Inventory build added an additional 0.3%, while domestic demand and consumption remained weak. We have remarked, before, on our perception that domestic consumption, a function of consumer confidence, must recover from very distressed levels and only when employment, pay and bonuses recover are the Japanese likely to stop saving and start spending. Fortunately, the annual bonus season is at hand and greater confidence in the future is likely to manifest itself in increasing pay levels from next year.
Deflator
Political opposition to further rate hikes has tended to coalesce around concern regarding continued deflation manifest within this activity data. Again, this needs some analysis too. Q3 2006 data revealed a deflator of -0.8%. Looking at endemic deflation on a sequential basis the data reveals an improvement from -1.2% over Q2 2006 and -1.5% over both Q1 2006 and Q4 2005. More significantly, the private demand deflator actually moved back into positive territory over Q3 2006 having been deeply negative in each period over the past twelve months. Furthermore, this quarter’s performance represents the first improvement since 1998 and provides clear evidence that after many years in the doldrums private sector price rises are gaining some traction.
The reason that the headline deflator remains in negative territory is that the difference, represented by the public demand deflator, fell very steeply over the latest quarter. Far from being concerned about this we suspect that it represents government success in encouraging competition amongst public sector businesses when competing for contracts (a good thing as it indicates a likely improvement in efficiency).
Tankan Survey Points To Future Growth
The continued strength of Japan’s Tankan Surveys of both large and small companies paints a rosy picture of medium-term prospects. Indeed the headline index of business conditions increased to its highest level in two years in September, while the index for non-manufacturers remains at a fourteen year high. Critically, what this implies is that Japan is likely to enjoy another strong year this year and again in 2007. Growth at or above 2.6% per annum should be sufficient to eliminate the negative output gap which had built up over the past few years and has proved the focus of political circumspection. Indeed the most recent Tankan Survey indicated that the country’s manufacturers were highlighting “insufficient” productive capacity for the first time since 1991. As the output gap narrows so the labour market tightens and wage inflation picks up. CPI inflation which had averaged -0.7% between 1995 – 2004 and fell to -0.9% in 2005, is expected to spring back to +0.5% over 2006, before rising again to 0.7% over 2007 and 0.8% in 2008. Again this should be sufficient to encourage policy makers to adopt action which is not being factored into the financial markets. Japanese base rates are not going to stop at 1.0% or so, as the markets imagine, but are likely to keep rising, possibly to 2.0% or 2.5% by the end of 2008.
Whither The Carry Trade
Carry trade strategy allows investors to sell a currency that offers a low interest rate (and consequently low borrowing costs) and use the proceeds to buy another currency which is supported by higher interest rates. By so doing the investor earns a return equal to the difference between the two interest rates. In the case of Japan, a prolonged period of negative real interest rates has encouraged investors to short the yen and long other, higher yielding, currencies. We have used this column in the past to point out the impact that the first trader will have when finally carry trade positions begin to unwind. The trigger will be the point at which the yen begins a sustained recovery on global currency exchanges. Investors should note that a massive $80bn is riding on the yen / dollar carry trade at present, an indication of the extent of potential future exchange rate volatility if any were needed. That little has happened so far is indicative of the fact that few are able to predict the outlook for base rates in either Japan or the USA with much certainty right now. One school of thought believes that the yen might actually weaken over the next twelve months. The reason for this is that while the Japanese base rates might actually rise marginally and US rates fall marginally, the differential (not the trend) will still be sufficient to ensure that the trade stays on. Low currency volatility, coupled with low global base rates should combine to create ideal conditions for supporters of the status quo. This view is reinforced by the idea that while Japan enjoys a trade surplus with the US, its share of the overall deficit has increased by dint of its deficit with China and higher oil prices. As is quite clearly the case (and supported by recent G7 communiques) it is China, not Japan, that has assumed centre stage in discussions regarding the resolution of global imbalances. Furthermore, some domestic investors, seeking to diversify holdings, have been taking money out of Japan and parking it in the US bond market.
There is absolutely no doubt that the carry trade has acted as a significant break on yen strength over the past few years. Whilst the arguments in favour of further weakness in the Japanese currency carry some weight they are, in our view, couched in the notion that conditions that prevailed in the past may continue into the future. The purpose of this piece is simply to reiterate this column’s long-held view that, when one looks back, at some point in the future, at the next twelve months conditions could look very different to those of the past.
Critically, the Japanese yen looks very undervalued judging by the economy’s robust revival. It looks even more undervalued when considered in the context of structural global economic imbalances. As regular readers of this column know, we ascribe a greater than 50% probability to the likelihood of aggressive US Fed monetary easing over 2007. We understand very well why policymakers procrastinate, however, we suspect that weak activity data will become sufficiently overwhelming to encourage the Fed to begin the rate cutting process in Q1 2007 and aggressively thereafter.
This is likely to usher in a period of currency volatility the like of which investors will not have seen since 1997/98. Slower growth will manifest itself in slower growth in corporate earnings which will, eventually (but inevitably) manifest itself in underperforming asset prices. When US bonds and equities begin to underperform, overseas owners of these assets are more likely to liquidate them, exacerbating the downward spiral, and to reinvest elsewhere.
Interestingly, for those readers who think we might be wrong, consider this. We suspect that this re-allocation process could be more aggressive if the US economic slowdown is muted and less aggressive if the slowdown is severe!!
The reason for this is that in the event of a “soft landing” other economies should perform relatively better than the US economy, implying better returns for investors from alternative overseas destinations. If the US economy experiences a “hard landing” we would expect the effects to be felt elsewhere with US exports to and imports from trading partners equally adversely affected.
In conclusion we expect the process of Fed easing to begin earlier than the financial markets believe and to be more aggressive when finally it comes. Equally, whilst the markets have priced in a partial rise in Japanese base rates, they are yet to price in a more aggressive policy stance in response to dwindling surplus capacity. Thus we see scope for increased volatility stemming from both sides. In short, 2007 should mark the beginning of the end of the yen / dollar carry trade, heralding in a period of currency volatility unseen over the past nine years.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley