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YUAN strong, YEN weak… and all's right with the world (apparently)

January 14, 2020

ref: - "Tail Risk" by Leo Lewis, The Financial Times, Companies and Markets

 

Without question, some people spend so much time looking for danger that they miss out on market moves driven by a more optimistic outlook. We wouldn't want to give them a hard time, and not only because we regularly fall into that bracket ourselves. Even if it's a result of a slightly cynical view of the world born of hard experience, a healthy dose of caution is a vital part of a trader's armoury. Sometimes that caution will prove highly beneficial to the bottom line, and sometimes it won't… like the first two weeks of 2020.

 

Back in early September, the Chinese Yuan (or renminbi) was trading just below CNY 7.20 to the US Dollar as evidence of the damage to the Chinese economy wrought by the trade conflict with the US began to manifest itself in an atmosphere of ill-disguised antagonism. Fast forward to the present and we approach tomorrow's signing of Phase One of a trade pact between the US and China with USD / CNY trading below 6.90. That's still makes the Yuan about 7% weaker than when the first shots of this affair were fired, but from a US point of view that's still a lot better than the situation 4 months ago or so. So much so in fact that the US has removed the "Currency Manipulator" tag it had slapped on China (and put the Swiss on watch instead). Whether or not you believe that the manipulation label is always 100% accurate and non-partisan, rather than being just a tool for the US' interests, is a moot point. The fact is that removing it itself encourages buying of Yuan, and the US will hope to see the Chinese unit strengthen further from here.

 

Oh, Happy Days… not so long ago it was all strife and bitterness between the two superpowers, now you might think it's all sweetness and light. But at the risk of coming over as overly downbeat, it would only be sensible to offer a little of that caution we were talking about. This agreement tomorrow is just the first (and very small) step on what will be a long and difficult journey, and we do not yet know all the terms of what will be signed off. There are huge problems regarding issues such as Intellectual Property and access to Chinese markets still to be sorted out. There are entrenched positions on both sides that will remain at odds even when the Chinese make gestures like buying extra US grain, say. There is a much-improved atmosphere right now, but with the volatile nature (and bargaining tactics) of the individuals involved who's to say how long that will last?

 

Be careful…

 

So, what's happening with the Japanese Yen? As the go-to safe-haven currency, one might have thought the US targeting of Qassem Suleimani would provoke a prolonged bout of Yen buying. In the event, and with the exception of the gold market, reactions in the other standard safe-havens was strangely muted. The Iranian response so far has been much smaller in scope and effect than one might have expected, but many good judges thought that there would be much more to come. That may yet be the case of course, but something unprecedented occurred.

 

We have to be mindful that we never lose sight of the desperate tragedy of a Ukrainian airliner being mistakenly shot down by Iran. Nevertheless, it has to be said that the Iranian admission of a terrible error on their part changed the geopolitical dynamic almost instantaneously, and markets have reacted accordingly.

 

Remember, before this all kicked off increasing numbers of Iranians, driven by the privations wrought by sanctions, were angrily protesting at the ruling regime in Teheran. The assassination of Gen. Suleimani by the US, if that's what you'd choose to call it, immediately brought millions out onto the streets to decry America. It seemed that if the US was indeed interested in any battle for hearts and minds, it had made a terrible error, aligning an Iranian nation (that had previously been showing signs of splits) squarely behind the regime and uniting militant Shias across the region and beyond. But the destruction of the Ukrainian airliner has once again changed things, with Iranians again protesting against the ruling regime and further action by Iran and its satellites against the US at least postponed.

 

Thus, you witness the extraordinary fact that Iran's shooting down of a civilian airliner that it thought to be a US air force plane is perceived to have REDUCED tension and has in fact calmed markets. That's another thing that we never thought we'd be writing.

 

Anyway, back to the Yen… when a safe-haven barely strengthens as tensions spike through the roof, perhaps we shouldn't be too surprised to see weakness once those tensions abate. Before the killing of Suleimani on January 3rd, USD / JPY was trading about JPY 108.25. Immediately afterwards, a half-hearted rally saw the Yen strengthen into about JPY 107.70. Today the pair are trading above JPY 110.00, with some calling for a new 110 - 115 trading range after a long and quiet period of 105 -110. Is the Yen losing its safe-haven lustre?

 

The argument goes that of the 4 standard requirements of a safe-haven currency -- strong economic growth, strong government finances, stable politics and liquidity (easy to trade in size) -- Japan fails the first two pretty badly. Ah yes, that's true, but there are Japan-specific factors that more than make up for that. Japan and Japanese institutions have enormous holdings of foreign assets. Not only does that contribute to a current account surplus, but of course creates massive buying of the Japanese currency should the money need to be repatriated in times of stress.

 

And of course, the Yen is the foremost borrowing currency in "carry" trades -- borrowing in a low or negative rate currency to convert into another riskier currency to lend at a higher rate. When trouble is brewing and dealers want to reverse out of these trades, that again creates a wave of repurchasing of the borrowing currency -- i.e. the Yen.

 

The trouble is that 1. Japan may have a large current account surplus but that will be undermined by a recent move into a trade deficit, and 2. with rates so low across the globe, the Yen is no more attractive as a borrowing currency in the carry trade than others, and according to Mr Lewis may be less so than the Euro.

 

It's much too early to say that the Jap yen's days as the safe-haven currency of choice are over… but after recent action, it's fair enough to ask a few questions.

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