This edition of Currencies and Markets is going to discuss the Yen Bomb.
The Yen has been a sister currency with the USD for at least two decades. As I recall, after around 1987 roughly speaking, there was concern over the USD and Yen valuation and an agreement apparently was reached for the BOJ to coordinate with the Fed to support the USD and carry on coordinated currency policy. I don’t have the details here. Then in the 1997 Asian crisis the Asians really dove into the USD for a haven after that for stability.
We also know the Japanese started the Yen carry trade in the early 90s to fight off the deflationary effects of their combined stock and real estate crash about 1990 and began lowering interest rates to near one percent. Welcome to QE zero.
Have you ever heard the term ‘patient zero?’
Since then Japan entered into now 25 years of stagnation and deflationary forces which they fought off with huge sums of public money, building lots of bridges to nowhere and basically supporting their banks and stock markets. Their national debt became the world’s largest by GDP at now near 300 pct. They will never be able to repay that.
Their economy is now saddled with huge debt and CONTINUING zombie banks. It’s like trying to swim with an anchor around your waist.
Right now, the Japanese government is caught in a fiscal crisis where they cannot raise their debt maximums unless they form a coalition to deal with this fiscal crisis. The clock is ticking and Japan is on the verge of running out of money for its national government functions, covering everything from pensions to the usual building projects to normal operations.
The bond markets have barely squeaked but they are going to start reflecting this. If interest rates rise a mere one percent, Japans debt service which is mostly interest will about double. And interest is just about the biggest part of their budget.
Japanese savers will at some point become discouraged and if any inflation rears its head, and this is possible, they will stop buying Japanese debt. And if fact we can easily imagine capital flight FROM Japan. If things get going bad enough.
Part two, the Yen carry trade in this
Now a weird phenomenon here is that if Japan has a fiscal crisis spin out of control, they will find managing the Yen virtually impossible. They will be able to hold wide ranges but the fluctuations will be massive. Remember what happened to the world currency markets in the Asian currency panics of 97/8 when the Yen rallied 30 pct. and caused utter panic across Asia.
A Japanese fiscal crisis and any rebellion in the bond markets would paralyze Japanese commerce, primarily from the standpoint that their industry would have no way to carry on business profitably with wildly gyrating Yen exchange rates.
At such a point, the trade partners will become reluctant to accept Yen payments and demand immediate payment in other currencies, the USD would be an example but there are lots of problems with that too now at this point, because I said the USD and Yen are sister currencies in my view, dating back decades with trillions of dollars’ worth of commercial and banking and FX linkages and market linkages related to this Yen carry trade. The USD is now the carry trade currency of choice in my view, but not completely taking over from the Yen for example.
If the Yen begins to enter a period of FX chaos, and sees rising interest pressures many results will follow like dominoes.
One, the major issue I am concerned with here, is the USD Yen linkage will possibly be broken. That would ultimately cause wild unwinding forces from the Yen and USD carry trades, which affect both central banks will fight tooth and nail.
If the Yen and later USD exchange rates start to fluctuate too much, many companies will do everything they can to minimize the FX risks, which cost them a TON of money when rates go askew from their plans, by the way.
Why do FX rates have such huge effects on companies?
Imagine that you build a Toyota vehicle, and your costs are in Yen, but the Yen falls in relation to the USD, or rises. If the Yen falls to the USD, then you get more Yen for that same $30,000. If the Yen rises you get fewer Yen. In a currency crisis, rates skew wildly from one extreme to the other, and your profits, which for cars is maybe 5 to 8 Pct. vanish. It becomes impossible to pay suppliers and everyone else if exchange rates are out of control. The ultimate effect is that every company in the supply chain ends up using its cash flow to manage the currency losses gains, and not running the company. This effect rolls all the way down the supply chain.
Big companies and small ones end up having to look months ahead for deliveries, making months long deals and when the goods are delivered and sold, maybe 5 months later, exchange rates have drastically changed. It’s a crap shoot.
The net effect of a Japanese fiscal crisis could paralyze Japanese industry. Especially if it lasts for even only one year.
The US would face the same issues on their side as well, but would have some longer flexibility, but still would face the same pressures, ultimately. If the US and Yen linkages break, and they are going to eventually, the combined economies of the US and Japan would falter badly at first, and possibly lead to a rapid deterioration of their bond markets and huge interest rate spikes. Their currencies, both would fall drastically.
Such a scenario would speed up the ultimate demise of the USD and Yen by years.
Since the USD and Yen are already faltering, one might say they would merely fall together, however the big problem for both of them is they are hitting a wall fiscally, and the bond markets are going to hammer them in interest rates. In other words, the Yen and USD carry trade being used to support their economies, support their stock markets, and support their currencies and their fiscal deficits, that party is ending.
If commerce is disrupted this badly, and FX rates become erratic, the only outcome will be lower production as companies attempt to stem the bleeding risks from the FX losses. More people will be fired. Even though fewer units will allay this problem, ultimately the governments will have to expand the safety nets to allay the unemployed. The cycle then shifts more burden to the governments, as they take over the economy, and the end result is higher fiscal deficits in an environment this time of RISING interest rates starting from near zero. Their budget deficits from interest alone will double then triple.
This is a recipe for a rapid currency collapse.
The question here is, will the Yen bomb blow up, and how long can Japan hold up its faltering and if you look at their fiscal deficits, running about Half, how much time do we all have before the Yen collapses, first maybe by spiking and crashing the financial markets, then followed by a fiscal collapse and bond riot in the Yen?
This is kind of like a supernova. First, the pressures of collapse build as the final fuel of (in this case cheap money which is about to end) is burnt faster and faster. Then implosion. But the implosion is a stupendous logarithmic burning of the final fuels, and you get a stellar explosion. It lights up the entire sky.
The currencies in question could rise rapidly, even as their bond markets falter initially. The last hot money would flow for a while to them. Ultimately, this supernova could suck in all the hot money on the globe, followed by total economic paralysis (remember a rising currency causes companies to burn cash in that country) and subsequent collapse of the currencies involved, and the need for a new currency which is pan national. This is the scale of what the Yen bomb can do. What this means is that all savings are burned. All companies become insolvent, and bond rates ultimately skyrocket putting a final clamp on the whole shebang.
In this scenario the entire FX complex of Asia, as well as with the West will be totally disrupted. Now since most of the inter Asian trade is manufacturing components for trade with the West, the FX chaos would clearly cause all of those supply chain dominoes, large and small to burn their cash too. IN short, total industrial bankruptcy in maybe a single year and paralysis, those companies run on razor thin profit margins. Talk about scaring China!
Gold would of course skyrocket eventually, albeit might be hampered in the beginning but would rise steadily. It would be the only metric out there that had any FX stability. Eventually gold would rocket. And not in a long time after the initial start.
The resource currencies would be seen as a haven at some point, but frankly as we stated this is a complex situation, and an economic collapse which would occur here would absolutely hammer the commodity complex. So this is dicey.