Yen to the rescue?

Japan's version of QE3 means that the yen has re-emerged as a heavyweight 'carry' currency

I have just a couple of observations to add to the copious analysis that has come in the wake of the Fed's announcement of a tentative timeline for the withdrawal of QE3. These pertain to the likely course of the rupee going forward.

First, exporters are not selling the dollar in significant amounts either in the spot or forward markets. Forward premiums that would have come down if they had sold dollars forward remain firm and have actually ticked up a little. The fact that exporters are staying on the sidelines suggests that they expect some more depreciation. The expectations and behaviours of market participants are known to drive self-fulfiling prophecies. Thus, the fact that exporters are holding back, expecting more depreciation, could itself drive a further fall in the rupee.

Second, it is difficult to miss the parallel between the run-up to QE2 (announced in November 2010) and the likely winding down of QE3. In both cases, the markets seem to price the likely impact of the event before the actual event was announced and traded flat post-announcement. The current surge in bond yields and the depreciation of currencies across the markets capture the consequences of withdrawal in dollar liquidity much ahead of the withdrawal itself. Thus, to try and predict the near-term equilibrium of the rupee, one has to grapple with the question: how much of the QE3 "taper" is already in the price? I am in the camp that believes that at levels of over 60 to the dollar, the rupee-dollar exchange rate is factoring in quite a lot of the likely impact of the "taper". I am, therefore, playing for some stability of the rupee in the 59 to 61 to the US dollar range in the near term.

An interesting correlation has emerged over the last few months in the rather bewildering world of international financial markets. The Nikkei, Japan's benchmark stock index, and the yen seem to be correlated almost perfectly, but inversely. That is, whenever the Nikkei goes up, the yen seems to depreciate against the dollar. This, at first glance, might appear a tad counter-intuitive, since it suggests that whenever investors tend to get bullish on prospects for Japan, money tends to flow out of the Japanese economy, causing the currency to depreciate.

However, if you think about it carefully, this is exactly what was happening with the dollar and the US stock indices until just a few months back. Episodes of increase in the US equity indices seem to be associated fairly uniformly with dollar depreciation. So, when money managers seemed to get comfortable with the prospect of better profits for American companies (and, presumably, growth prospects), they seemed to be selling the dollar.

You can perhaps seek a solution to this puzzle by thinking about two things - one, the so-called carry trade in which investors borrow in low-interest currencies and invest in high-yielding assets; and two, the "risk-on-risk-off" phenomenon that characterised investor behaviour ever since the 2008 financial crisis.

What was going on then? US stock market indices like the Dow Jones served as a proxy for risk appetite. As risk appetite soared, so did the stock indices. Think of another bunch of investors who were in the business of making their returns from the gap between borrowing costs in the US, and higher but riskier returns in other markets. Rising risk appetite encouraged them to place bets on risky, high-yielding assets - ranging from European bonds to emerging market currencies. This was the carry trade funded by cheap dollars created by QE, and resulted in dollar depreciation.

Cut to Japan today. With the advent of Japan's version of QE (in which the Bank of Japan is printing almost as many yen in dollar terms as the Fed) coupled with rising US yields, the Japanese currency has re-emerged as a heavy-weight "carry" currency. The introduction of "Abenomics" (of which this manic yen printing is an integral part) has focused investors' attention on Japan's rekindled growth prospects and the market. But the success of "Abenomics" is far from guaranteed, and investors have been swinging from episodes of extreme bullishness on growth prospects to extreme despair. This, in turn, has driven extreme volatility in the Nikkei.

Take this a step further. With signs of stability visible in the US, rapidly shifting expectations of Japan's growth prospects have been flipping the global risk switch on and off. As a result, the Nikkei has emerged as a key global risk indicator. Bullishness on Japan means risk is "on" and the Nikkei goes up. This also means carry trades funded by yen borrowings into riskier assets, causing the yen to depreciate. Bearishness on Japan, on the other hand, means a falling Nikkei, a reversal of the carry trade and consequent yen appreciation. This, on a two-dimensional graph shows up as a perfect inverse correlation.

Why bother with this correlation at all? For one thing, as long as this correlation persists and the Nikkei and the yen remain volatile, the carry trade will also be volatile with periods of yen outflows interspersed with a pull-back. Thus, one cannot depend on a steady flow of yen liquidity to compensate for reduction in dollar liquidity. This holds for the Indian asset markets, too. The best outcome from the emerging market perspective would be a slowly declining or flattish Nikkei coupled with sustained depreciation - this was, incidentally, the configuration that prevailed in the pre-2008 heydays of the yen carry trades. The author is with HDFC Bank. These views are personal