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EM rout presents a challenge to Japan's weak yen policy

Marshall Gittler | Head of Global FX Strategy | IronFX
Wednesday, 5 Feb 2014 | 7:22 PM ET

While many pundits – including me – expect the yen to weaken this year, the market never moves in a straight line. The crisis in emerging markets is negative for the yen over the longer term, yet in the short term it's a big positive that will likely see the yen gain strength as the turmoil continues.

The emerging market crisis is bad for Japan in the long term as these are important markets for Japanese goods. Over half of Japan's exports go to emerging markets, with 18 percent going to China alone and 29 percent going to Greater China, including Taiwan and Hong Kong. Thus, a slowdown in these markets or a reduction in their purchasing power would offset to some degree the boost to exports that Japan gets from a weaker yen.

(Read more: Stand by: EM turmoil sparks credit crunch fears)

However, it may help to increase inflation insofar as the price of imports rises, but that's "bad inflation", not "good inflation" stemming from a rise in demand that allows companies to raise their profits and prices.

Sha Ying | CNBC

But before that happens, the yen is susceptible to safe-haven flows. That is, when people get nervous about their investments, they tend to buy currencies that are considered particularly safe, especially the yen and the Swiss Franc.

The Swiss Franc I can see – Switzerland is a neutral country with a thriving economy, a large current account surplus, and virtually no government debt. But in Japan there are a number of red flags: the economy is slowing; the trade surplus has turned into a persistent deficit; the population is aging and shrinking faster than almost anywhere else; and to top it all off, the government's finances are a mess – it's more indebted than Greece, a country that nearly blew up the euro zone.

This issue has puzzled others as well. Some researchers at the IMF recently did a study of the yen as a safe-haven currency and determined that yes, it did have that quality, owing to its strong net foreign asset position and its large and liquid financial markets, particularly the currency market.

(Read more: Emerging markets—Is it time to bottom fish?)

The study concluded that unlike the Swiss Franc, the yen appreciates during risk-off periods not because of capital flows or expectations about Japanese monetary policy, but rather through changes in investors' portfolios using offshore derivative transactions. It's not even clear that any money actually changes hands; it's possible that prices adjust to changes in belief that are common to market participants. In other words, the yen might be appreciating during risk-off periods just because people expect it to.

Whatever the reason, it tends to happen when there are problems in emerging markets. For example, during the 2011 EM rout, when EM stocks fell 27 percent between July and September, the USD/JPY moved in tandem with EM stocks. The yen appreciated 6.4 percent against the dollar during that period, eventually hitting a record high in October of that year. We're now seeing a similar episode.

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What might turn the yen around?

If the yen starts to strengthen too much, then we will probably start hearing comments from government officials about how currencies should reflect fundamentals and that they are watching the markets closely – hints that they are considering intervention. In the current environment, when EM countries are already upset about the Federal Reserve's refusal to consider the global impact of their policy, I doubt if the Japanese authorities would intervene directly in the market.

However, the EM crisis could encourage the Bank of Japan to add to its support for the economy in an attempt to offset the likely drop in overseas demand just when the government is hiking the consumption tax.

(Read more: The 3 culprits behind the emerging markets rout)

In any event, the EM crisis does not seem likely to end any time soon, thus it appears that the yen will continue to appreciate for some time. I wouldn't be surprised to see USD/JPY at around 98 in the not-too-distant future if the current uncertainty persists. That would be weak support at the 76.4 percent retracement of the rally from the pair's October 2011 lows. Stronger support would be at the 61.8 percent retracement level , but that's at 93.95 – we would need to see a much greater intensification of the EM rout to hit that level.

Perhaps the best hope for yen bulls is that economic indicators in the U.S., which have been disappointing recently, become so disappointing that the Fed stops tapering. That would be disappointing in its own way: substituting monetary stimulus for real growth. But it's not unthinkable at this point.

The author is the Head of Global FX Strategy at IronFX, an on-line trading firm specializing in Forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously Head of the Forex Committee at Deutsche Bank Private Wealth Management.

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