Tokyo, we have a problem.
Last week, market tumult stemming from the U.K.'s vote to quit the European Union drove the British pound to its weakest levels in three decades.
Yet it also sent investors flocking to traditional safe haven assets like the U.S. dollar, gold and the yen, the latter surging against every major currency as the results of Brexit became clear: Dollar/yen spiked from a Thursday high near 107 to a two-year low near 99. Meanwhile, the pound lost more than 8 percent against the yen and the shed more than four percent to hit a three-and-a-half-year low.
The currency's strength was enough to prompt the Japanese government to hold an emergency meeting on Monday, Reuters reported, in order to craft a strategy to counteract yen strength. In currency market parlance, that suggests the Bank of Japan (BoJ) could intervene at any time to sell the very yen traders are trying to buy—something the central bank already does on a frequent basis.
Japan needs a weaker yen to boost the economy, but at least for the moment investors need a safe haven even more. So which impulse will win the tug of war?
"Classic risk aversion is in full manifestation," said Alessio de Longis, portfolio manager in the global multi-asset group at OppenheimerFunds. "It's a defensive currency in an environment where global growth is slowing."
De Longis pointed out that the yen was already on a strengthening trend even before Brexit, with fears about the global economy festering.
The fallout means the currency is rapidly becoming a proxy for investors' need for a shelter in a storm of continued uncertainty—and that complicates Japan's efforts to engineer a sustainable economic recovery.
There might be a limit of what the BoJ can do to prevent the yen from strengthening.Richard Hastingsmacro strategist, Seaport Global Securities
A weak yen is a linchpin of Prime Minister Shinzo Abe's policies—better known as "Abenomics" — to revive the world's third-largest economy, which is also one of the globe's largest exporters. Although Japan has muddled through decades of sluggish growth, its lack of external debt and a still wealthy society makes it an attractive haven for investors scampering from global risk aversion.
"The [looming] exit of the U.K. from the European Union has intensified the safety attraction of Japan and the Japanese yen," said Joseph Trevisani, a chief currency strategist at Worldwide markets.
"Japan is hardly a robust economy but it is an island and not about to collapse," he added.
"Despite the failure of Abenomics to promote growth traders prefer the stability of Japan to the widening circle of questionable economies around the globe."
However, the yen's is now operating as a proxy for global risk aversion, raising risks for Japan's trade balance. In April, the country posted a deficit, but exports grew 8 percent year on year.
BoJ intervention risks
A strengthening currency imperils that export growth, and heightens the risk that the BoJ—one of the most assertive central banks in the world in terms of managing currency risk—could sell yen to counteract the upward pressure.
Brexit by itself "doesn't have black swan characteristics. It isn't like something appearing out of nowhere with big scale size and power," said Richard Hastings, a macro specialist at Seaport Global Securities, speaking about a destabilizing event like the 2008 collapse of Lehman Brothers—the tinder that sparked a worldwide financial panic.
Nonetheless, "the problem for assets is that it encourages the BoJ to…make sure that these currencies don't strengthen too much," Hastings said. "Part of the mechanism is to crush the yields on their government bonds, and that pulls down yields on U.S Treasury yields," which are already at historically low levels, he said.
That said, "there might be a limit to what the BoJ can do to prevent yen from rallying," he added—especially as the veneer of European unity splinters.
In fact, markets may already be fanning the embers of the next crisis. While all worldwide bourses tumbled on Friday, OppenheimerFunds' de Longis pointed out that certain European markets fared worse—which could be an ominous sign.
Friday's "price action tells you everything you need to know: who are the worst performing markets? Spain and Italy," he said, noting the bourses of both countries reeled by double digits—even worse than London's exchanges.
Those flashpoints "are treated as the worst performers, and indicative of where the next risks lie," de Longis added.