Is Yen Strength Due to China Diversification?

Yesterday we saw the yen climb to a 15-year high against the US dollar as investors turned risk averse after the Fed and Bank of England’s dovish outlooks for their respective economies rattled markets. This was coupled by Chinese growth data showing that growth continues to slow in the Far East, reigniting concerns of a double-dip in the global economy.

However, we have seen an extended period of yen strength which stretches past the most recent resurgence of investor fears regarding the outlook for the global economy and the dollar’s fall from favour, back to the beginning of the financial crisis. Recent data from Japan’s Ministry of Finance showed China bought $5.3 billion worth of Japanese assets in June, adding to the $20 billion worth of assets it had already purchased earlier in the year. It is our position that the yen, and other currencies, may continue to strengthen if China continues to diversify its massive $2.5 trillion in foreign exchange holdings. As China moves into other assets and deploys some of its vast reserves the value of these assets is likely to move up, and fast.

The perception at the moment that Japanese assets are probably less risky than those in the US is certainly making them more attractive and as a by product boosting the yen further. The WSJ reported that Zhang Ming, an economist at the government backed Chinese Academy of Social Sciences, said Japanese government bonds are safer than Treasury’s since the Japanese debt is held mostly by Japanese investors. “The Japanese government bond market is closed, and the yen currency rate has been strong against the dollar in recent years” Zhang said, according to the Journal report. “These are important reasons why Chinese investors increased their [Japanese government bond] holdings”.

As such, we believe that the extended period of yen strength against the US dollar is a result of ongoing Chinese diversification as it hedges against its massive US Treasury holdings. Since Japanese assets at present are the quality asset of choice we look to see the yen maintain its upward trend as long as the Bank of Japan will allow without intervening in the market.

It is perceived that Japanese administration has a so-called ‘line in the sand’ at the 85.00 yen to the US dollar level and will intervene both verbally, and with other tools to weaken the currency. The administration enacts these policies to protect its exporters who have seen their stock prices tumble as the yen has strengthened, and a day after the Japanese currency hit its high shares of auto giant Toyota Motor Corp tumbled to a one-year low. The concern for exporters is that their repatriated profits will be impacted by the yen’s rise, affecting in a negative way many exporters’ bottom lines.

In a world of debt a cash reserve of $2.5 trillion is a formidable weapon and if it is not used wisely can cause serious distortions in the pricing of assets as China piles various assets. We believe that this is what we are seeing play out in the yen at the moment and only when the US economy shows real signs of recovery will China be at greater ease with its heavy weighting of US dollars and Treasury’s. But, for as long as the US economy continues to stumble along China will search for tools to hedge against its positions including diversification.

Written by Jonathan Granby, DailyFX Research Team

If you wish to contact the author with comments or questions email jgranby@fxcm.com

If you wish to discuss this or any other topic feel free to visit our Forum Page.