The Land of the Rising Currency

Japan is a heavyweight economy, argues this currency market veteran, but after 15 years of poor performance, the investment inflows don’t reflect this. But recently, something changed: In-flows are rocketing…

The financial press speaks of "the dollar" as though it had a single price. But it doesn’t – it’s priced against every other currency according to how traders feel about the United States and its economic condition, as well as the conditions in the other country.

The euro-dollar exchange rate gets the most publicity, but the movements in this currency pair don’t necessarily reflect movements in other currencies, such as the Japanese yen-dollar pair. Indeed, I’m projecting a sharp drop in the dollar against the yen in the months ahead.

But before I elaborate on my prediction, I need to address some common misconceptions about the relative value of currencies. I think this will help you understand why the U.S. dollar refuses to fall against the euro, as some of the "fundamentals" say it should. It will also help you understand why I’m now recommending the yen.

The value of a currency is closely related to the strength of its underlying economy. In the case of the United States, despite staggering budget and current account (trade) deficits, a deteriorating geopolitical situation and many other imponderables, it still has the world’s biggest and strongest economy.

Japan’s Economy: Economic Strength

What is economic strength, anyway? Let’s define it as adaptability, meaning the flexibility to change with changing conditions, including the ability to recover from external shocks. And that’s the key to understanding why the dollar has actually climbed against the euro for most of 2004. Europe’s GDP growth this year will be 1.6% this year at best, compared to 4.5% or so in the United States. Even if the Middle East explodes and oil prices spike higher, the euro is unlikely to gain against the dollar and might even fall, as the United States is much further away from the trouble, geographically, and less dependent on imported oil than Europe.

An economy perceived as "strong" attracts inbound investment. And that’s the key to understanding the euro’s February-April 2004 correction from near $1.30 to $1.176. Each month, the United States needs an influx of $40-45 billion to fund its current account deficit. But a great deal more money than that actually flows in – it’s more like $70-90 billion per month.

In contrast, while Europe is running a current account surplus of around $15 billion per month – it is losing almost twice as much in combined direct investment and portfolio outflows. In March 2004, a monstrous 23.9 billion euros flowed out of Europe. The month before, Europe drew IN undefined27.7 billion euros. That’s a net reversal of $60 billion.

The folks who decide how to allocate capital on a global basis don’t miss information like this, and it makes them wary of investing in Europe, or more specifically, the euro. So now they are turning their attention to another strengthening economy – Japan. While the capital inflow into Japan is miniscule in comparison to the United States and Europe, it’s rapidly increasing. And that bodes well for both the Japanese equity markets and the Japanese yen.

Japan’s Economy: Underweighting Japan

Make no mistake – Japan is a "heavyweight." Japan is the world’s second-largest economy, after the United States. Since global capital allocations are roughly in line with a country’s share of world GDP, or its equity market’s share of world stock markets, Japan should be attracting a sizeable share of global capital. But for the last 15 years, investment inflows into Japan have been tiny.

One big reason is that the Japanese economy is only now pulling out of a tailspin that began in 1989, when the Japanese stock market crashed. Ever since, most international investment houses have "underweighted" Japan.

Another reason investors persistently snubbed Japan came about because of structural problems in the financial sector and excessive government debt, which caused ratings agencies to rank Japan in the same class as Botswana.

You can question whether rating agencies have their heads screwed on straight – the willingness and ability to repay government debt is quite different in an advanced society like Japan than it is in a developing country like Botswana – but never mind. Tokyo was simply not an important destination for global capital.

And just over a year ago, the most widely followed Japanese stock market index, the Nikkei 225, fell to 7,600 – down from nearly 40,000 at its 1989 peak. However, experienced traders knew that this was the best time to buy – sensing a historic low – and money has been pouring into Japan ever since.

Over the last two decades, the median level for the Nikkei has been about 20,000. Today, it stands around 11,000, so a return to "normal" means it could double. Foreign buyers are helping it along. In the year to March 2004, the latest figures available, net foreign purchases of Japanese stocks totaled a record $125 million.

Now, $125 million is not a huge sum of money, particularly in relation to the multibillion-dollar capital flows flowing in and out of Europe and the United States. But this relatively small money flow could be only the beginning of a delicious trend. Profits at many Japanese corporations are soaring into the double digits, especially for exporters like Honda and Sony. And they are selling into Asia, not just the United States, where imports from Japan are falling back.

Japan’s Economy: A Sustainable recovery?

The big question is whether the recovery will be sustainable. While most banks are operating profitably, one or two large banks are still hemorrhaging money, and their collapse could spook investors. Another concern is that after a decade of deflation, prices are starting to inch up. The Bank of Japan has already started to prepare the markets for a rate hike, sometime in the next 12-24 months. That seems awfully far away today and is not a serious concern for investors.

It will be a historic moment when the inflation level passes 0. No other country has experienced deflation since the Great Depression, and as a nation of savers, the Japanese were particularly reluctant to be goosed into a spending spree that can help end a deflationary cycle. As economist John Maynard Keynes said, opening the money spigot in this situation was like "pushing on a string." The government even gave away money vouchers and put a time limit on them to get consumers to spend – but even then, not all of them were used! But now employment is rising, disposable income is rising and the propensity to consume is rising.

It may be too soon to say Japan is back, but the probability is high. In fact, Japan’s GDP in the latest quarter surpassed even the U.S. GDP at 5.4% annualized, although the year won’t come in that good. Money follows growth – not only portfolio investment, but also direct foreign investment (e.g., foreigners buying real estate, setting up new plants and buying companies). The Japanese frown on foreign ownership of Japanese assets, but even that is beginning to change.

In sum, fortune favors the yen right now. But until very recently, the Japanese government didn’t want a stronger yen…they feared it could choke the recovery. Indeed, to avoid the strengthening currency, the central bank spent $220 billion between September 2003 and April 2004, mostly selling yen and buying dollars. In some months, Japanese citizens were, in effect, subsidizing the U.S. trade and budget deficits combined.

Finally, just three months ago, Japan abandoned its interventionist policy. The official explanation was that the economy was strong enough that exporters no longer needed the protection of an artificially weak yen. Another possibility is that the United States and Europe pressured Japan to end the policy, which artificially strengthened the euro and the dollar.

Whatever the explanation, the Japanese have, at least for now, sworn off intervention. However, the Japanese finance minister has warned that Japan has the sovereign right to intervene in its own self-interest, and we should believe him. Were the dollar to fall against the yen from today’s 110 to 80, as it did in 1995, the Bank of Japan would hardly be silent. But a more modest fall, say to 100, would probably be acceptable.

Indeed, the dollar is already falling against the yen. From the dollar’s peak against the yen at 135 in February 2002, it has fallen 18.5%, to 110. If the yen continues to move to the same extent and at the same pace, it will reach 100 by year-end 2004. Currently, the dollar has been rallying and has pushed the yen up beyond 111. It is my assertion, therefore, that this represents an excellent buying opportunity in anticipation of a yen blast upward.


Barbara Rockefeller
for The Daily Reckoning
August 10, 2004

The typical investor poses himself two questions. Are bonds coming off a top, headed down? And will stocks bounce off this bottom, an oversold extreme, to resume the climb?

As to the second question, our answer is simple: probably not. And what does it matter anyway? You make money by buying low and selling high. Stocks are high; buying them now starts you off on the wrong foot.

But to the first question, our reaction is almost schizophrenic. Yes, well, maybe…perhaps not. We think U.S. bonds may go up…but we think you’d have to be crazy to buy them.

It is "inflate or die," as Richard Russell puts it. But then creating money out of thin air won’t stop the deflation in financial assets or reverse a worldwide economic slump.

It will only destroy the paper currencies in which this magic money is calibrated. Real money, by contrast, will be more appreciated than ever before.

Be there first.

Eric, are you there?


Eric Fry, from Manhattan…

– The stock market finally mustered a meager rally yesterday, but it withered shortly before the closing bell. The Dow settled less than one point lower at 9,815 and the Nasdaq slipped two points to 1,775. The dollar also drifted slightly lower, while gold inched above $400 an ounce to $400.15…In short, Monday was a good day for equity investors to ignore the stock market and play badminton…or rugby, depending upon one’s inclinations.

– Meanwhile, over at the NYMEX, crude oil dazzled investors with another record-setting performance. The lifeblood of the global economy soared to within a whisker of $45 a barrel. A barrage of worrisome headlines from both Iraq and Russia sent the oil bears scurrying for cover. "Iraq’s Southern Oil Co. stopped pumping oil," Bloomberg News reported, "after militia troops threatened to attack oil facilities…[Meanwhile], OAO Yukos Oil Co., Russia’s largest oil exporter, said the government renewed a freeze on shares of its main Siberian oil unit, reviving concern its assets will be seized to settle a $3.4 billion tax bill."

– Doesn’t it seem a bit odd that the lingering dispute over a $3 billion Russian tax bill is costing the global economy billions of dollars each and every day? The oil price has jumped more than $10 a barrel since Yukos’ troubles first surfaced last fall. Maybe the United States should bail out Yukos in the hopes of pushing oil back below $40 and save American consumers billions of dollars in the process…Wouldn’t that be a more efficient use of taxpayer dollars than annexing Iraq…or feeding lunches to U.S. senators?

– Bailing out Yukos could also serve to bail out the stock market…at least for a while. Since the rising price of crude oil is the stock market’s principal nemesis, a falling oil price could become the market’s new ally. But a U.S.-led Yukos bailout makes far too much sense to ever become a reality. So let’s turn our attention to what is, rather than what should be…[Ed. Note: Just before we change subject, we can tell you that our free special report on the oil market is ready and proving to be extremely popular reading. This is extremely pertinent…

– The nation’s long-suffering mutual fund investors were relieved by the market’s relative stasis yesterday, but hardly satisfied. Losing money slowly is little solace to an investor who hopes to make money quickly by buying overpriced tech stocks. The bubble burst four years ago, but some investors still struggle to understand that stocks sometimes fall…a lot. Gone are the days when the most successful personal financial plans relied upon pulling cash advances from Visa cards and buying shares of the Amerindo Technology Fund.

– The once-ascendant Amerindo and its preposterously pompous manager, Alberto Vilar, have been laid low by the financial market fates. The Amerindo Technology Fund has cascaded more than 80% from its bubble market peak in early 2000. At the zenith of the bubble, Mr. Vilar confused his supreme good fortune for supreme genius. However, in this, the post-good-luck era, the "genius" hypothesis may require a brief re-examination.

– Here at The Daily Reckoning, we never fall victim to the sin of hubris, mostly because we have never performed a deed worthy of hubris. Neither do we confuse good luck with genius; that’s because we have been immensely lucky to have avoided any form of good luck that could be confused with genius.

– We feel very lucky that we may arise every morning and draw a deep breath; we also feel very lucky that a Starbucks coffee shop is almost always within walking distance; and we feel luckiest of all that we are not geniuses. The burden of genius is simply too great to bear. Perhaps genius is a suitable trait for the likes of Albert Einstein and Alberto Vilar, but not for us.

– Now that share prices have been falling – more or less – for the last four years, investment geniuses have become quite scarce. Today, mutual fund managers are merely well-paid mortals, not the demigods that the lumps once imagined them to be. And these mortals, as a group, have been amassing a lengthy record of earthbound performance.

– "The average large-cap core fund – the segment most comparable to the S&P 500 Index – was trailing S&P index fund returns this year by 1.7% through Thursday," Barron’s notes. In other words, the average large-cap fund had lost about 3.6% in 2004, compared to a loss of 1.9% for the S&P 500.

– Vilar, for his part, has weathered the last few months in fine form. His Amerindo Technology Fund has slipped only 2.8% in 2004, compared to the Nasdaq’s hefty 11% drop year-to-date…Congratulations Alberto!

– We suspect that lumps won’t tolerate losses graciously. If they continue to lose money, they will respond by selling their mutual fund shares…and then by selling some more. The mutual fund managers would then be forced to sell stocks, after which the lumps might sell more mutual fund shares, after which…well…you get the idea.


Bill Bonner, back in Arizona…

*** Pater has split from familia…temporarily. We are on our way to Vancouver to give a speech. We will catch up with the troop and the news later. Stay tuned.

The Daily Reckoning