Japanese Yen: A Tectonic Shift in Progress?

The Yen has strengthened considerably in the immediate aftermath of the Tohoku earthquake – the largest in recorded Japanese history –as rising uncertainty spurred repatriation flows, with Japanese investors cashing out across the asset spectrum. The process seems likely to continue until the full impact of the disaster is ascertained and a forecast-able set of variables emerges.

FX Intervention – Will They or Won’t They?

This presents a clear challenge for Japanese authorities: on one hand, a stronger Yen threatens the critical export sector that will be seen as instrumental in helping the economy recover; on the other, the Yen's increasing purchasing power will help to dull the cost of recovery efforts for individual as well as public and private entities considering so many goods and resources in Japan are imported. On balance, this means policymakers (who have a well-documented penchant to intervene into FX markets) will be tempted to manage Yen volatility rather than push prices in a given direction, with as-yet unknown results. It can be said however that a period of knee-jerk volatility is likely ahead.

Is an End to Deflation in Sight?

Over the longer term, the most significant question concerns the quake’s implications for Japan's persistent deflation problem. On balance, prices are likely to be pressured higher. The disaster severely damaged the Fukushima Daiichi nuclear power plant and the government has acknowledged that the threat of radiation leakage is increasing. Regardless of how the endgame to this aspect of the crisis plays out, Japan is likely to be far more skeptical about the use of nuclear power in the future, hinting at a shift toward traditional sources such as oil and coal for more of its energy needs. Additional demand will nudge up prices, which ultimately promises to spill over into overall CPI inflation.

Meanwhile, the government has already signaled that it will divert a large bit of the funds that had been marked for a variety of services (from child care to toll-free roads) toward reconstruction efforts. This along with private-sectorreconstruction will stoke economic activity, adding to inflationary pressure. The Bank of Japan’s record-setting liquidity injections in the immediate aftermath of the quake certainly encourage this trajectory. While the extent to which these price gains are temporary or otherwise is uncertain, they could potentially alter the deflationary reality that Japan has lived with for two decades, permanently changing the currency’s trading dynamics. In the most extreme scenario, this foreshadows rapidly rising interest rates and a Yen that structurally changes from a carry trade funding currency into something of a high-yielder.

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