Over recent weeks, extreme currency movements have been the main theme of financial markets. The currencies of the world’s two largest economies, the US dollar and the Japanese Yen, have been beacons of light. In just the last three months or so, every other major currency has declined sharply against the dollar and the yen.

Deleveraging’ is the simple answer to why these two currencies are displaying unparalleled strength. However, we need to go much further back to really understand these recent violent currency moves. Firstly, let’s look at the extent of the dollar and yen’s appreciation against the world’s major currencies.

The dollar has been stronger against everything other than the yen, while the yen has been by far the strongest currency.

Performance of various currencies against the US Dollar over the past three months



Performance of various currencies against the Japanese Yen over the past three months



Clearly, liquidity around the globe is rushing back to the source, and sucking the life out of financial markets in the process. From an economic perspective, we can rationalize these moves on a short term basis but longer term, there does not appear to be any justification to support US dollar strength.

The US and Japan’s modern day economic relationship rose from the ashes of World War Two. The US helped rebuild Japan’s shattered economy and opened its vast consumer market to Japan’s fledging export industry. Over the next few decades, Japan’s economy turned into an industrial and export based powerhouse.
This has seen Japan turn into the largest creditor nation in the world, running massive trade and current account surpluses, year after year. Instead of reinvesting these savings and restructuring its domestic economy the savings have flowed to the US and all around the world.

For example, the Japanese are the largest holders of US treasuries, with investments totaling US$585 billion at the end of August. Elsewhere, the Hungarian Forint is collapsing as Japanese investors withdraw their support for that economy. The Japanese have invested heavily in Hungary and other smaller economies in recent years as these countries borrowed to speculate in housing (including Australia). That trade is now unraveling.

Put simply, a lack of productive investment opportunities at home, combined with low interest rates, saw Japan as a nation finance other investment opportunities around the world. Now the risk tide has turned and the Japanese are bringing their funds home at a rate of knots.

Given Japan’s creditor nation status, we believe a strong yen makes sense. This is the natural force of the market trying to push for an overhaul of the Japanese economy. Domestic consumption should rise and saving rates should fall. Cheaper imports will encourage this change in trend.