One look at FX trading this morning and all one can see is surging volatility and, for lack of a better word, turmoil. Which is precisely what Albert Edwards said would happen in his latest note overnight (released just as the USDJPY briefly breached 125) in which he observes that the Yen has now fully broken its 30-year support and predicts that "a new round of currency turmoil" is beginning.
From the SocGen skeptic:
The break of ¥122 took much longer than I expected but it has just occurred and I think yen weakness will become a dominant driver of markets and economies. We reiterate the particular vulnerability of China to yen weakness – in a replay of the events that led up to the 1997 Thai baht devaluation. China has big deflationary problems and cannot tolerate any further rise in the renminbi. Indeed, on one key measure, China is already in outright deflation."
As a reminder, Edwards was the first who predicted that the breach of key USDJPY 122 support would unleash accelerated selling to 145, something which he timeframed as taking place by March 31. Judging by the recent acceleration in the Yen's collapse, maybe he was just early.
Having finally crashed decisively through ¥122 last week (see chart below), what has changed since November? Two things - deflation fears in the west have ebbed away recently but the economic situation in China has become more precarious. The most important thing as the yen sets off another round in the global currency war is that China in now in outright deflation and cannot tolerate renminbi appreciation. As the yen drags down other regional currencies, and the renminbi is forced to participate in a competitive devaluation, deflation fears will surely quickly reignite in the west."
Currency wars aside, Edwards believes the Yen is trading now as it was some 18 years ago - when brisk Asian growth cratered and led to the 1997 Asian crisis, once again as a result of manipulated, artificial currency values due to dollar pegs.
Yen weakness at this juncture reminds us of events before the 1997 Asian crisis. Back in the mid-1990s, a period of undervalued Asian currency pegs to the dollar had stimulated strong growth in the region and large balance of payment (BoP) surpluses. Then the whole process went into reverse as inflation picked up, real exchange rates soared, competitiveness was lost and BoP surpluses turned to deficits. That process has happened again in EM economies in general but importantly, also in China. Their real trade-weighted exchange rates continue to rise, even as the bilateral dollar rate remains stable (see chart below).
And while the SocGen strategist started off predicting the future level of the USDJPY, in a world that is more inextricably linked and globalized than ever, the logical conclusion to this analysis is what happens in China once Japan loses control of its currency devaluation, forcing not only South Korea to join QErrency Wars which it has been inches away from for the past 3 years, but also Beijing even over the Politburo's chronic fears of capital outflows.
China may wish to keep the renminbi stable at this time while the IMF is currently considering including it in the SDR currency basket. But the economy is simply not in a position to withstand a major yen decline bringing down the currencies of its competitors in the region (and the additional deflationary impulse). I remain convinced that China must start guiding its currency down against the dollar and it can do that easily now it has a BoP deficit by doing absolutely nothing (ie not intervening any longer to hold it up)! China will also take the IMF?s recent declaration that the renminbi is no longer undervalued as justification for these actions - link.
Worrisome deflation is already being imported into the US, especially from Japan (see chart below). China (blue line) has yet to participate, but a further round of Asian devaluations will inevitably see waves of deflation heading westwards ? as in 1997/98. Watch this data closely.
Edwards' conclusion: "The US and eurozone remain a hair?s breadth from outright deflation. A weak yen could push them over the edge into deflation proper as China is forced to finally join the global currency wars."
That's ok though, because in the meantime, record stock prices will hit even recorder levels, making the record rich even richer, if only on paper.