Yen Investing

Content provided by Rui Wang, CLS Investment Research Analyst

The Japanese economy has been weak for two decades. One of the obvious symptoms has been its pro-longed deflation. To help mitigate the deflation, the Bank of Japan (BOJ) plans to double its balance sheet within just two years, and they’ve set a 2 percent annual inflation rate target. My thought is that Real Interest Rates (RIR) and Exchange Rates (ER) are the keys to reflate the Japanese economy.

In order to end the long nightmare of deflation, the Japanese government has subsidized the weak domestic spending by increasing government spending and deficit, which has led to a debt-to-GDP ratio of nearly 200 percent. However, such policy has not been successful. One of the major reasons is that the BOJ did not push down the RIR enough to revive the economy, unlike what the Fed did after 2008.

Higher RIR discouraged domestic spending when the demand was already anemic, which then significantly dragged the recovery. High Japanese RIR further appreciated the yen against the dollar, which put pressure on export orientated companies such as Sharp and Sony. The yen then pushed the prices of imports down further and pulled up the RIRs. Without material intervention from the BOJ, this downward cycle has haunted the Japanese economy for over a decade.

The BOJ’s current attempt to reflate price levels is an aim to end this vicious cycle. If inflation approaches the 2 percent target, the RIR will be pushed down near zero while the yen will move lower or at least sustain at the current level. The low RIR will help to stimulate spending while the price inflation will help to raise workers’ wages which further boosts consumer confidence. Theoretically, such an increase in spending will generate the industrial production growth which pushes the aggregate spending up further. This positive cycle would eventually revive the stagnated Japanese economy.

The above cycle depends on the comeback of inflation – which will not be easy. As mentioned before, the prolonged period of government deficit and the significantly high debt level did not successfully reflate the economy. With Nominal Interest Rates already near zero, the only tool to create inflation is the ER. Without lowering the price of imported goods, it is hard for people to foresee any inflationary pressure. Therefore, my thought is that to successfully create inflation and push down the RIR, the BOJ must manage to maintain a cheaper yen. If the yen cannot sustain its downward path, or at least sustain its current short-term low against the dollar, the market will not buy into the inflation scenario and the reflation effort is highly likely to fail.

This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation, and the particular needs of any specific person. This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument. There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended and should understand that statements regarding future prospects may not be realized. Investors should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance.
0922-CLS-4/24/2013