The Yen Bubble: Chronicle of a Burst Foretold
by Albert Loo, Global Co-Head of Interest Rate & Forex Derivatives for Corporates and Didier Latouche, Global Head of Forex for Corporates, Societe Generale
In an economic context that is globally dominated by considerable uncertainty, financial markets in general, and foreign exchange markets in particular, have adopted a wait-and-see policy. This paralytic phase, marked by an absence of strong trends, has one notable exception: the yen. The Japanese currency is undergoing an impressive rise, accentuating the increase in value that started in 2007 - USD/JPY and EUR/JPY parities have thereby fallen to fifteen- and nine-year lows respectively.
This trend is such that there are obvious similarities with a potential ‘bubble’ in which the price of an asset durably disengages from its fundamental factors via a violent, uncorrected movement. Indeed, the continued rise of the yen is obviously occurring in a highly negative economic context: persistent deflation, zero interest rates, very poor public finances and chronic political instability. The Japanese currency’s current resilience can only be explained by a high degree of aversion to risk and extremely low long rates in the US.
Faced with this situation, the Bank of Japan felt it needed to intervene on the foreign exchange market for the first time in six years to stop the yen from rising further. However, one should remain cautious as to the efficacy of such interventions, and while the short-term risk is an additional rise in the currency in light of the global market context, the margin for further increases should start to diminish and the main medium-term scenario can only be one of progressive decline.
One should keep in mind that no financial asset price can remain removed for any prolonged period from its ‘true value’, which is based on its fundamentals. When the market starts to refocus on the key domestic drivers of the economy, leaving aside current external drivers that are artificially ‘doping’ the yen, the bubble will necessarily burst.
We must remember that the impact of the fall in the price of an asset in this scenario is generally comparable to that of its rise. With the rise of the yen observed over the past three years, there is a significant potential for decline over the medium term. This risk must be taken into account as the yen is reaching levels today that are as high as they are worrying.
Among exporting firms, the luxury industry gathers all the necessary conditions to take long-term advantage of this situation, which appears less as a risk for luxury goods leaders than a strategic opportunity. The Japanese domestic market amounts to up to 20% of their total sales, let alone the share represented by Japanese clients when they travel abroad. For these structurally exporting companies, the strength of the yen is a definitely timely opportunity at a moment when the Japanese market is contracting as it has entered its maturity phase. This historical market phenomenon thus enables them to cover future flows at attractive yen levels. On the one hand, margins are high enough to finance foreign exchange hedges beyond the budget horizon, especially via options.On the other hand, due to a less violent competition on prices than in many other industries, a temporary deviation from the industry budget standard, through adapted strategies, will impact only marginally the market share in case of an ongoing rise in the yen. If the yen bubble should burst in the mid-term, a two- to three-year hedge secured to current levels would strengthen the margins or delay the rises in prices at a moment when the Japanese market will probably slow down again. Such an opportunistic strategy, based on hedging budget horizons to a farther extent than the current 12-month standard, would have to be a part of a global reflection about sales strategy and use the flexibility that options can offer.
This situation is a good example of how industrial companies, when faced with extreme foreign exchange levels, can take a major turn in the foreign exchange hedging policy of their highly probable future cash flows. However, such strategic decisions demand strict conditions: operational margins must be high enough to finance the hedge; the sales basis or the considered costs must have a minimum stability; pricing power must be good; and a strong consensus must be found within the operating committee.