Why JPY?
One of the most prominent features of the “rising dollar”, if not the “rising dollar” itself, was an almost out of control shortage in FX basis. Though cross currency basis swaps with Japan received all the attention, with very good reason, the basis was off against the euro, franc, and a host of other majors. These things happen from time to time, but they don’t stay that way and get all out of proportion like that. From that sustained situation we can only infer a lack of banking capacity, a shortage of money dealing that in the pre-crisis era policed these kinds of spreads, retaining predictable hierarchy (or, if you prefer, covered interest parity).
But bank capacity is not the only capacity. There are other monetary channels inside and around the eurodollar system. Corporations, for example, have easily raised funds from bond markets and through other means domestic or offshore where local banks might often run into trouble. Thus, it would be quite the cost savings for a company in, say, Japan to issue dollar-denominated debt and swap that debt back to local yen currency where the negative basis was large enough to offset any interest rate differential. It would have to be considerable because Japanese companies, like their European counterparts, can float bonds at or around 0% in their own denomination.
So it is far from a perfect substitute, an arbitrage boundary, if you will, and therefore is nothing like when money dealers roamed money markets with, they thought, unlimited capacity and potential. That brings us to JPY.
As difficult as it is to perhaps easily and intuitively understand, we can predict the (reported) level of Japanese holdings of UST’s by the direction of the currency. One of the biggest problems in understanding the wholesale dynamics of currency exchange is the belief that the rate of exchange is something like a price or a value. It is merely a number functioning in one of the basic monetary purposes, a unit of account.
Traditional monetary economics assigns a judgment to the direction of a currency, though in more recent days it doesn’t ever reason why. Under a gold standard or fixed exchange system, such would be relevant and even important; devaluation actually meant something in a way it doesn’t today (has any nation that “devalued” in the last ten years experienced the “stimulative” effects they sought? No.). Economists got what they wanted, for currencies float which really means their exchange rates are relative expressions of monetary mechanics rather than economic or financial fundamentals.
The “rising dollar” in Japan meant instead a yen exchange value that actually rose whereas the dollar exchange against the yen fell. This description by itself tells us nothing about what is going on, it is only through outdated views that we so often attempt to give these results meaning. To be perfectly blunt, the yen was supposed to drop against the dollar, therefore all FX arrangements were set as if that were the irrefutable baseline; basis swaps to naked forwards. If the yen instead rises (sustained), all that says is “something” changed to break with that convention; the direction largely irrelevant since all that matters is contra-convention.
If JPY is at 120 today and you expect it to be 125 next month and 135 next year, then your FX basis is deployed as if that will be the case. If everyone else thinks the same way, their positions largely match and agree with yours. Therefore, it is cheapest to put on positions that follow that pattern. If for whatever reasons enough participants are no longer able to continue to provide capacity to keep the trend intact, then increasingly counterparties are going to bid backward to try to entice other counterparties to re-establish predictability – even if it is non-bank corporate treasuries that can easily borrow dollars from the bond market.
