'Armed confrontation' could end currency's special status
Even after a North Korean missile flew through Japanese airspace, the yen remained in demand Tuesday as investors scrambled for havens amid escalating fears of conflict in East Asia.
But the yen's go-to status as a haven asset--a position that currency has maintained in some investor minds since the early 1990s--might be shaky if the crisis graduates to a military confrontation, market participants said.
North Korea fired a test missile that flew over (http://www.marketwatch.com/story/north-koreas-outrageous-missile-launch-over-japan-inflames-tensions-again-2017-08-29) the northern island of Hokkaido and into the Pacific Ocean, causing Japanese Prime Minister Shinzo Abe to call it an "unprecedented threat." The United Nations Security Council is reportedly due to meet late Tuesday to discuss the launch.
The move sparked a global stock market selloff that saw U.S. equities sink in early trade before recovering ahead of midday. Other traditional havens, including Treasurys, gold and the Swiss franc, also rallied in response.
As a neighbor to the rivals sharing the Korean Peninsula, with only the Sea of Japan between them, Japan might find itself on the front line of any military face-off between Pyongyang and the U.S. It is also home to U.S. military bases, making it a potential strategic target. Besides the physical fallout, a war would have repercussions for the Japanese economy, Kuniyuki Hirai, head of FX trading at MUFG said.
"If armed confrontation materializes in North Korea and Japan would be attacked...there is no sense that the yen would strengthen," he continued. "The yen may outperform the South Korean won, but the current [trading] situation might be a bit exaggerated or overestimate the yen's strength."
Given that, the yen might not maintain its traditional status as a haven asset, and could weaken in the event war breaks out in the region, according to Neil Mellor, chief strategist at BNY Mellon.
The relationship between the Japanese currency and risk aversion is based partly on Japan's current account--a broad gauge of the country's trade in goods and services, including employee wages and income from investments. Export-oriented economies like Japan's tend to run current-account surpluses, meaning that their income from overseas trade exceeds payments to foreign entities. In fact, Japan is the world's largest creditor nation.
That, according to the textbook explanation, means when investors dump assets perceived as risky in response to a scare, Japanese investors repatriate some of those foreign holdings, creating demand for yen-denominated assets.
That can happen even when Japan is at the center of the scare. The country's currency, for example, rallied sharply in 2011 (http://www.marketwatch.com/story/yen-reverses-sharply-higher-after-quake-2011-03-11) in the wake of a devastating earthquake and the Fukushima nuclear disaster, as it did following the deadly Kobe earthquake (http://www.marketwatch.com/story/yens-1995-post-kobe-rally-tough-to-repeat-2011-03-11) in 1995.
"At the time of [Japan's] earthquake [and subsequent tsunami] in 2011, the yen rallied against almost everything else. This kind of repatriation is typical, so there's a precedent here despite the geographical closeness [to North Korea] and the fact that Japan is home to U.S. military bases," Hirai said.
But equating a natural disaster and a war is a mistake, Hirai continued. Japanese insurance firms have a lot of money invested abroad and repatriate their cash when it is needed for large scale insurance payments, like in the case of the 2011 earthquake, which accelerated the strengthening of the yen.
"[W]ar is a so-called force majeure in insurance disclaimers, and [they] have no liability to pay for the damage," he said.
The unwinding of the so-called carry trade, in which investors borrow low-yielding currencies like the yen and Swiss franc and then sell them, using the proceeds to buy higher-yielding assets, is also a factor in the yen's haven status.
Ultralow interest rates in Japan have made the yen an ideal funding currency for traders pursuing the carry trade.
If rising geopolitical tensions demand the unwinding of riskier positions elsewhere that are funded with Japanese yen, this reversal leads to traders being forced to cover short position in the yen, buying it back and thereby propelling it even higher, said Marc Chandler, global head of currency strategy at Brown Brothers Harriman, in a Tuesday note.
On Tuesday, the U.S. dollar hit a low of Yen108.27, the lowest level since November 2016 against the yen . The greenback most recently bought Yen109.45 on Tuesday afternoon in New York.
Meanwhile, Japanese authorities are unlikely to be fond of the idea of a stronger yen because it would have a negative impact on efforts by Prime Minister Shinzo Abe and the Bank of Japan to break the country out of the grip of deflation.
"We should be mindful that [a stronger yen] might lead to at least verbal intervention from the Bank of Japan," Mellor added.
Some market participants suggested another way to play the traditional haven currencies could be to match them against one another, such as in the case of Swiss franc/yen pair . Both are considered a good place to put money in turbulent times, but given Switzerland's enormous geographical distance from Northeast Asia, it could easily be considered more resilient compared to the yen.
Meanwhile, the yen jumped 0.5% against the South Korean won , buying 10.2880 won on Tuesday. In comparison, the regional risk barometer hit a high of 10.479 won per one yen in the first half of August when tensions were heating up.
The South Korean won would, of course, suffer in case of a war as the nation would face physical confrontations along its Northern border. Yet, anybody convinced that a war is still unlikely could do well in buying won/yen options to take advantage of any strengthening of the South Korean currency if and when stability returns to the Korean Peninsula.
"If there are any negotiations [with North Korea], the won would spike against the yen," Hirai added.
(END) Dow Jones Newswires
August 29, 2017 14:37 ET (18:37 GMT)