Japanese yen: defining the range

Over the past month the Japanese yen has traced out a range against the US dollar which may well constrain it for some time ahead. The weakness of the Japanese currency came as expectations for a Chinese revaluation faded and the recovery of early last month was based on signs that the period of extreme monetary ease by the Bank of Japan may be coming to an end.

The importance of speculative position building and liquidation is driving the Japanese yen, as can be confirmed by looking at the net speculative long- or short-yen positions on the futures market of the International Monetary Market.

While futures are only a small part of the foreign exchange market, positions taken there can reflect overall speculative activity. A few months ago, large short yen positions were built in anticipation of an increased portfolio outflow by Japanese investors in the new fiscal year.

However, these flows failed to materialise and the increased political pressure on China to revalue its currency forced these positions to be liquidated. The market takes the view that a Chinese revaluation would allow other Asian currencies to strengthen against the US dollar, as maintaining competitiveness against China has been an important part in Asian resistance to currency appreciation.

The perceived increase in risk of Chinese revaluation is what took the US dollar-yen exchange rate down.

By the middle of last May market expectations for a Chinese revaluation had started to fade. The US Treasury report on the foreign exchange policies of US trading partners stopped short of naming China as a currency manipulator and this helped reduce expectations for an imminent move.

With expectations of a Chinese revaluation fading and the US dollar performing well elsewhere, short yen positions were again rebuilt and the US dollar-yen rate appreciated early last month.

More recently, however, US dollar strength has started to fade a little and the Bank of Japan has moved to allow the current account deposits of the commercial banks to drop below its set target.

The Bank of Japan has been pursuing an explicit 'quantitative easing' strategy since 2003 and had repeatedly increased its target for these deposits to ensure that the markets are awash with liquidity.

The objective of the Bank of Japan's policy is to bring deflation in the country to an end and it has tried to stimulate the economy not only by keeping short-term rates at zero, but by adding excess liquidity into the banking system to keep rates low right across the yield curve.

For the Bank of Japan to get back to 'normal' monetary policy, this quantitative easing will first need to come to an end. At a meeting last May, the Bank of Japan amended its directive to allow temporary falls below the target level if it judges that liquidity demand is "exceptionally weak", which presumably means when it fails to attract sufficient bids for its money market operations.

However, HSBC Research does not view this as an effective tightening of monetary policy as the overnight call rate remains at zero. In fact, the target for current account deposits could probably be cut significantly without having a material impact on interest rates.

Nevertheless, with the market short of yen, any hint that the period of extreme monetary ease in Japan may be ending has been enough to cause positions to be closed and, as a result, the Japanese yen has been rallying again.

Looking forward, the fundamental pressures on the yen are much more neutral now than they were in 2003 and early 2004. At that time, the large Japanese current account surplus, combined with large equity portfolio inflows, exercised strong upward pressure on the yen. This was met by unprecedented official intervention aimed at preventing the yen from strengthening too much.

In recent months, the balance of payments accounts have been close to flat. The current account surplus has narrowed a little and this has largely been offset by a net portfolio outflow. In this environment, short-term flows can be the dominant force in driving the marketplace. However, it is unlikely that this will be enough to force the US dollar-yen out of the present range that has constrained it in the past four months.