Trying to read between the lines of BOJ doctrine, even as the Yen continues rising contrary to what the economic data out of Japan time and time again suggests it should be doing, Morgan Stanley is out with a report that attempts to quantify the probability of a Yen intervention. And even though there has been no official instances of intervention since 2004, MS feels that "increased JPY strength from current levels is increasingly likely to trigger official FX intervention." As this relates to the economy caught in the biggest deflationary vise in the last two decades this does not surprise us very much.
How does one quantify the probability that the Central Bank will no longer play ball with Bernanke's printing fantasies? From MS:
In earlier research, we introduced a model to gauge the probability for FX intervention based on the following factors: (1) market mispricing of relative economic growth outlooks, (2) significant deviation of the real exchange rate from historical trend, (3) excessive market positioning and (4) increased momentum in exchange rate moves (Please see Introducing an FX Intervention Model 10 Jul 2008). According to our framework, model results indicating probabilities below 20% imply a low level of intervention risk, results in the 20-30% range are consistent with an elevated risk of potential FX intervention while results above 30% suggest a significantly high risk of FX intervention.
Updating our USD/JPY intervention model shows the probability of official action rising from 29% last week to 34% this week (Exhibit 1). The key factors contributing to an increased intervention risk include the mispricing of longerterm relative growth outlooks (Exhibit 2), the deviation of the real effective JPY exchange rate from its longer-term average (Exhibit 3), and a sharp rise in long JPY positions (Exhibit 4). The latter factor accounts for most of the rise in intervention risk over the past week. Our results suggest that increased JPY strength from current levels is increasingly likely to trigger official FX intervention.
So if the JPY returns to its Thanksgiving high 14 year high against the dollar, will the BOJ get involved? MS believes that to be the case: primarily due to the growth differential between Japan and trading partners. What MS may have missed is that the G20 have broadly sacrificed trade at the altar of dollar devaluation, and in the pursuit of artifical capital market appreciation (worldwide bubbles). Don't believe us? Just ask Mr. Bernanke what was discussed behind closed doors at any/all G-20 meeting in 2008/2009.
Based on our analysis, the fundamental background makes FX intervention in USD/JPY more likely and market positioning suggests intervention is more likely to be successful in weakening the JPY. First, the current level of the USD/JPY exchange rate appears at odds with expected growth differentials between Japan and its main trading partners. Our metric gauging the market pricing of these differentials is at a +1 standard deviation, implying that investors are pricing in significant outperformance of Japanese growth versus its main trading partners.
This appears to be at odds with the disappointing result for Q3 GDP in Japan, which was revised down to 1.3% from 4.8%, and Morgan Stanley Research forecasts for future growth. In addition to the metrics for growth differentials, positioning also makes a strong case for FX intervention in the JPY. In fact, the change in this factor is most responsible for the recent rise in intervention risk. JPY net long positions on the IMM reached a new high for the year, rising to 57k contracts, which is 84% of the record high of 65k seen in March 2008 (Exhibit 4). It is notable that JPY net longs have risen so sharply in an environment that has not been characterized by significant deleveraging. Historically, JPY positioning has been a key metric in assessing the potential for intervention in USD/JPY. Given that FX intervention tends to garner more success if it is able to catch speculative investors wrongfooted, indications of a lopsided market figure prominently on policymakers’ radar. especially as such conditions are also usually indicative of a one-way market.
Another factor to consider is that domestic policy in Japan appears more conducive to generating a weaker JPY. That would suggest that policymakers would have the wind at their backs if they choose to intervene. In general, FX intervention can be an effective tool in impacting market expectations when it is reinforced by policy and macro dynamics. As outlined by our colleague Takehiro Sato, the BoJ’s recent expansion of quantitative easing is only the beginning of additional accommodative policy measures likely over the next year. The BoJ’s stance would make any FX intervention to weaken JPY more credible, in our view.
The not too surprising conclusion:
The heightened risk of JPY intervention indicated by our model suggests that the level of the exchange rate is out of step with underlying fundamentals. Against that backdrop, we see a heightened risk that additional JPY strength from current levels is likely to trigger official intervention. While FX intervention alone does not usually mark a turning point in a currency’s trend, policymakers tend to act when markets are at extremes. So from that standpoint, FX intervention is often a precursor of a shift in valuation, at least in developed
We had been JPY bulls throughout 2009. But in our view the trend is now for a weaker JPY, and we target USD/JPY at 101 by end 2010. Recent data imply that JPY strength is set to take a larger toll on the economy and will need to be offset through more aggressive policy measures to combat deflation pressure in Japan. JPY should lag its G10 peers in 2010, in our view, and its underperformance may be most extreme against currencies of economies where central banks are exiting their emergency policy stances, such as CAD.
A weaker yen (per MS) and a weaker Euro (per GS) imply a stronger dollar. Ben Bernanke and a few trillion more in MBS needing endless purchasing and constant market intervention would beg to differ.