Without actually doing much besides using rhetoric, I believe that Shinzo Abe, the newly elected prime minster of Japan, has single-handedly changed the psychology of the yen’s exchange rate and set it on a potential fast track to depreciation—it fell from under 80 yen to the U.S. dollar to 90 yen to the U.S. dollar in the last two months (as of January 15, 2013).1 The more yen it costs to buy US$1, the weaker the yen’s value.
Abe has been relentless in a multi-pronged approach to weaken the yen. He has called for targeting inflation of 2%, set an aggressive nominal GDP growth target, threatened to change the Bank of Japan’s (BOJ) mandate (and has the power to do so2) and discussed introducing more fiscal stimulus measures as well as the creation of a large investment fund to buy foreign bonds (to weaken the yen even more)3. Thus far, the yen has weakened versus the U.S. dollar strictly in anticipation of all these measures, as each of them will take time to be implemented. [Japan ETF Doubles in Size as Yen Falls]
This brings to mind Hank Paulson’s famous line during the financial crisis of 2008, when he said, “If you have a bazooka in your pocket and people know it, you probably won’t have to use it.”4 Abe’s “bazooka” has been particularly effective in getting the market to adjust its expectations and has done much of the heavy lifting to accomplish his goals regarding a weaker yen in very short order—without Abe even firing any shots yet (i.e., without seeing discussed policies through to full implementation).
When is Abe’s mission accomplished?
Currency movements are hard to predict. In economic terms, currency moves theoretically are tied to relative inflation rates through a concept called purchasing power parity. Abe is certainly trying to change Japan’s economic course from being primarily characterized as “deflationary” to “inflationary” (with a specific goal of at least 2%). Inflation expectations have crept up slightly, but they are still well short of even just a 1% target—a policy actually set in February of 2012.
Based on Bloomberg estimates, Japan’s five-year estimated inflation rate is just over 83 basis points.5 This rate is well short of Abe’s 2% target, but earlier in the 2012 calendar year, Japan’s estimated five-year inflation rates were a negative 60 basis points—meaning that investors in five-year government bonds collectively expected price levels in Japan to fall approximately 60 basis points per year for five years. Japan thus has managed to get inflation expectations to increase somewhat, but to be fair, much of these gains came earlier in 2012, when the Bank of Japan announced a 1% inflation target during the month of February and before Abe called for more aggressive targets.
The moves we’ve seen in the yen thus illustrate, at least to me, how much the yen’s value is tied to market sentiment. And sentiment undoubtedly has changed with Abe’s rhetoric. One place this sentiment can manifest itself is in the resumption of global carry trades.