The US dollar just hit a record all time low against the Yen. And it may only just be getting started.
How much Yen is my US Dollar worth? ¥80 … No, ¥79 … ¥78 … no …. ¥76 Yen (See partial graph below). This played out in a span of less than half an hour this afternoon. For businesses this is completely chaotic. Imagine negotiating a million dollar deal where the price goes up by $50,000 in the span of half an hour. More important than the dollars lost in the moment is the long term volatility in which this precipitous drop introduces to an already fragile business environment.
What exactly is Foreign Exchange?
The foreign exchange market (forex, FX, or currency market) is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies(source)
So why is this massive drop so important? I believe the situation was well summarized by a commenter on zerohedge.com. XPolemic wrote the following on Wed, 03/16/2011 – 17:58. The full comment thread can be found on ZeroHedge. Links added by yours truly:
1. Japan is, by and large, an export economy.
2. An export economy sells more products when it’s currency is weak, because those products are relatively cheap in the countries it exports to (due to exchange rate purchasing power).
3. As export economies mature, their currency tends to appreciate, but in Japan’s case, the BoJ intervened and began a program of purchasing US treasuries to strengthen the dollar and weaken the Yen, and lowering the Japanese primary rate (bonds, overnight cash).
4. This led to a credit bubble/real estate bubble which ridiculously indebted everyone in Japan.
5. As a consequence of (4) BoJ lending to the domestic market came to a virtual halt, but given the low interest rates, foreign lending increased (particularly to US, Eur and AU). This is known as the carry trade. Borrow short in Yen, lend long in local currency.
6. The FX risk of the carry trade (5) is only lightly hedged, given the traditional stability of the BoJ and Yen interest rates (most common hedge are FX swaps). As a result, carry trade books have significant exposure to Yen, which traditionally has not been a problem, given previously mentioned stability of the BoJ.
7. The stability of the BoJ is now challenged, given that they now need to (a) calm financial markets with liquidity injections (b) will need Yen for re-building 40,000 homes and (c) they have a massive nuclear plant that may go critical soon which would be a clusterfuck of biblical proportions.
Consequently, the BoJs ability to weaken the Yen by purchasing UST is now severely compromised, and so it is likely that (1) the undervalued Yen will appreciate to the market price and (2) the BoJ will need to sell UST to pay for (a,b and c) above.
So everyone who was massively exposed to the YEN will have a big problem due to this massive plunge. Who is that? EVERYONE who makes large financial decisions (All banks, all hedge funds) because up until this week, the YEN was an excellent investment. Check out what was posted just 4 days before the … earthquake … and tsunami … and nuclear … and now financial …. disaster struck:
Japanese Yen Stability Should be Questioned with FX Volatility at 30-Month Low. The Japanese yen has shown relatively limited levels of activity – in fact the implied outlook for movement over the coming three months is at a three-year low. In fact, the volatility reading for the broader currency market is at its lowest level since August of 2008. This isn’t a reading to suggest direction so much as it is reason to worry about a dramatic return of volatility – though volatility usually jumps in bear markets.
Because Japan lent out its Yen so cheaply, big institutions could borrow it and made cheap subsequent loans. Unfortunately for those big institutions, the interest on those loans will no longer cover the cost of carrying those loans. So, they are in big trouble again, which means that WE are in big trouble, given the US’s penchant for catering to these institutions.
Furthermore, US Treasuries will be strongly and negatively impacted now that Japan will need to sell its US Treasuries in large quantity to pay for cleaning up and rebuilding. What an amazingly
suspiciuos unbelievable turn of good fortune for Bill Gross over at PIMCO, who shocked the financial world by selling ALL of the company’s holdings of US Treasuries two days before the earthquake.
So, one of the biggest questions remains: What will we do without Japan buying up all of our debt? Japan has been one of the biggest holders and one of the historic largest purchasers of US Treasuries. We can only wait and see as Japanese ATM’s run dry , the Bank of Japan injects $420 Billion into its market, and the US rapidly approaches its debt ceiling.