FX markets deal Japan another blow

By Felix Salmon
March 16, 2011
this one would be a monster -- the yen managed to strengthen by 4% against the dollar and almost 6% against the Australian dollar in a matter of minutes.

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If FX moves were measured on the Richter scale, this one would be a monster — the yen managed to strengthen by 4% against the dollar and almost 6% against the Australian dollar in a matter of minutes.

This move is overwhelmingly due to technicals, rather than fundamentals: you don’t get jumps like this because people have donated a few million bucks in aid which is now being converted to yen. It’s not even because Mrs Watanabe is cashing in her high-yielding Aussie dollars because she needs the cash in yen right now. No: this is a prime example of how even an economy the size of Japan can be buffeted hard by international capital flows in the multi-trillion-dollar FX market.

The Japanese currency is now stronger than it has been at any time since WWII, at exactly the point at which it needs to start cranking up its export engine. And on the face of it the move doesn’t make a lot of sense: countries’ currencies are just as likely to fall in the wake of a natural disaster as they are to rise.

But what we’re seeing here is a function of ultra-leveraged hedge funds unwinding their carry trades. If you borrowed yen and invested in higher-yielding currencies like the Australian dollar or the South African rand, you made lots of money so long as the rate of appreciation of the yen was lower than the interest rate you were getting in the target currency. But when the yen starts to appreciate dramatically, you get margin calls, which force you to buy a lot of yen in an illiquid market, which in turn drives the yen up even further, which in turn not only increases the size of your margin call but also triggers a large number of stop-loss orders and other triggers embedded in exotic FX options. The result can be massive, as we’ve just seen.

The G7 is reportedly going to try to help out “to support financial stability in Japan”, but it’s far from obvious what they can do: currency intervention is rarely effective when you’re trying to push against the direction markets naturally want to go. It seems that Japan, after being hit first by an earthquake, then by a tsunami, and then by nuclear disaster, is now going to have to suffer the effects of a volatile and overvalued currency as well. It’s the last thing the country needs, and it does help bolster the case for some kind of Tobin tax.

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