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Blog: The Yen Has No Reasons To Strengthen

The reaction within the currency markets on Friday to the tragic events in north-eastern Japan was an understandable one. After an initial knee-jerk sell-off in the yen as the news first broke, the Japanese unit climbed rapidly through the course of the day as investors talked of capital repatriation and, more generally, about the unwinding of JPY-funded carry trades.

However, as I have considered the topic further over the course of the weekend, I've come to suspect that this JPY strength may, itself, prove short-lived.

The first issue I have is with the comparisons being made between the Kobe earthquake and the events of this weekend. As tragic as the Kobe earthquake was (over 6,400 people were killed), it was still a relatively localized event. This time around the situation has been complicated by the subsequent tsunami.

Black smoke rises from an oil industrial complex caused by the massive 8.9-magnitude earthquake in Ichihara city, Chiba prefecture. The earthquake shook Japan, unleashing powerful tsunamis that sent ships crashing into the shore and carried cars through the streets of coastal towns.
Toshifumi Kitamura | AFP | Getty Images
Black smoke rises from an oil industrial complex caused by the massive 8.9-magnitude earthquake in Ichihara city, Chiba prefecture. The earthquake shook Japan, unleashing powerful tsunamis that sent ships crashing into the shore and carried cars through the streets of coastal towns.

Certainly the initial estimates of the cost of the disaster are that it will be at least as high as that of Kobe. With the nuclear emergencies in Fukushima complicating the situation further (rolling electricity blackouts are expected across the country in the coming weeks), there can be little surprise that Prime Minister Naoto Kan told a press conference: "This is the worst disaster Japan has faced since the Second World War."

All this comes in the aftermath of a fresh contraction in the economy in the fourth quarter of last year and at a point where Japan is already carrying a debt burden equivalent to roughly 200 percent of its GDP.

Indeed, it is worth remembering that it is only a matter of weeks ago since Standard & Poor's cut Japan's sovereign debt rating by one notch to AA- (the first cut since 2002), saying that the government lacked a "coherent strategyā€¯ for dealing with its growing debt burden.

Negative Fiscal Picture

Given that (entirely sensibly) the government will likely announce emergency spending to fund rescue and clean-up efforts and to resuscitate the economy, it seems reasonable to suppose that the current plans to balance the state's books will be pushed back even further out.

With this hugely negative fiscal picture being matched by the fresh quantitative easing measures announced by the BOJ overnight, the JPY is starting the week facing the prospect of looser fiscal and monetary settings. As such it is difficult to make an argument in favor of currency strength.

Indeed, given that any sustained recovery in Japan's economy is likely to be export-led, it seems reasonable to suppose that the Japanese government would be grateful for this one small piece of relief. It was therefore hardly surprising when Finance Minister Noda made his feelings clear on this matter Monday morning.

A person who is believed to be have been contaminated with radiation is carried to ambulance
Jiji Press | AFP | Getty Images
A person who is believed to be have been contaminated with radiation is carried to ambulance

All of this brings me to the broader situation that investors face at the start of this week. In addition to the disaster that has hit Japan (and the ongoing nuclear emergency), they also face what must be seen as a less than satisfactory outcome to the euro zone summit, the threat of a U.N -led no-fly zone being imposed over Libya and continued political uncertainty in the Middle East. It therefore seems likely that in the face of the multiple stories, the most logical outcome will be a broad retreat from risk.

Given that the USD has been the primary funding vehicle of choice over the past year, it seems reasonable to suppose that it should ultimately prove one of the prime beneficiaries of the events of the past few days.

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The author is Simon Derrick, head of currency research, BNY Mellon