Is the Japanese Yen Headed for a Long Decline?

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The Japanese yen has already fallen by more than 12% against the U.S. dollar since Nov. 1, 2012 - and it could still have further to fall.

That's mainly because the Bank of Japan appears likely to go along with the wishes of the Liberal Democratic Party, led by newly elected Prime Minister Shinzo Abe, and step up its attempts to eliminate deflation by using "unlimited easing" and setting a 2% inflation target.

Most of the Japanese yen's weakness we have seen so far stems from aggressive jawboning by Prime Minister Abe and other LDP leaders. And outgoing Bank of Japan Governor Masaaki Shirakawa has appeared likely to go along with Prime Minister Abe's demands for closer cooperation between the government and the central bank.

The Bank of Japan's Monetary Policy Committee (the Japanese equivalent of the Fed's Federal Open Market Committee) is in the middle of a regularly scheduled two-day meeting. It is widely anticipated that the BOJ will agree to additional easing measures - most likely purchases of Japanese government bonds (JGBs) - and will formally adopt the government's 2% inflation target.

Why the Japanese Yen Reversed Course

The Japanese yen had been gaining strength against most major currencies until last fall.

Money Morning Chief Investment Strategist Keith Fitz-Gerald attributed last year's gains in the yen to its status as a safe haven from stormy waters in the U.S. and Europe.

"Japan's currency has risen to a 25-year high on nothing more than worries about Europe going bad and U.S. debt," Fitz-Gerald said last year. "It's a classic "safe-haven' rush that's driving the yen."

Now that the LDP government and its aggressive "Abe-nomics" have come to power, the yen has started to weaken, and Japanese shares have risen in anticipation of the BOJ Monetary Policy Committee meeting.

Economists are concerned that aggressive easing by the BOJ will start to have an impact on JGB yields if investors begin to anticipate inflation. Yields on 30-year JGBs have started to rise and are now at 1.98% compared with 1.95% last month.

However, yields on shorter-duration JGBs up to 10 years have fallen. In addition to increasing its purchases of JGBs, most economists expect the BOJ to announce that it will expand its asset purchases, currently limited to bonds with less than three years to maturity, out along the yield curve to bonds with up to five years to maturity.

If this is true, then it makes sense that yields on shorter-duration bonds are falling while the yields on long-term bonds are rising.

But the real issue here is velocity of money.

What Could Happen to the Japanese Yen

Velocity is a measure of how much additional GDP you get for each additional dollar (or yen) circulating in the economy.

Adding money to the economy is worthwhile only if velocity is greater than 1.0x. In other words, if the velocity of money is 1.5x, then each additional dollar in circulation can be expected to add $1.50 of GDP.

In Japan, the velocity of money is currently 0.55x. That means that each additional 100 Japanese yen in circulation produce only 55 yen of additional GDP.

To put it another way, 45 yen out of every 100 yen created by the BOJ disappear from the economy, largely in the form of cash hidden in dressers or under beds. That is why it is so difficult to ignite inflation in Japan.

If the BOJ succeeds in hitting its 2% inflation target, a massive amount of money that had been hidden away will suddenly be looking for a way to return. And as this money returns to the economy, velocity will rise, and that is when Japan starts to run the risk of hyperinflation.

If the market thinks hyperinflation will kill the value of the yen then investors will ditch it.

Or, as Fitz-Gerald said when referring to what would happen when the yen was no longer a safe-haven, "The yen will get dropped like a hot pan getting pulled from the oven."

Some of Prime Minister Abe's advisors and members of his government have already said that the Japanese yen should not get "too weak" because it would result in higher prices for imported energy that would be harmful to the Japanese economy.

We are already seeing higher precious metals prices in anticipation of tomorrow's (Tuesday's) announcement from the BOJ.

"The BOJ introducing fresh stimulus would be positive for precious metals," analysts at Mumbai, India-based AnandRathi Commodities Ltd. said today in a report cited by Bloomberg News.

Much depends upon what the BOJ decides at the end of its two-day meeting tomorrow. Additional stimulus measures could convince markets to sell the yen and to buy precious metals.

Prime Minister Abe should be careful what he wishes for. He might get it.

Money Morning's William Patalon III today wrote a special report for his Private Briefing subscribers explaining a move to make now to profit from the Japanese yen in 2013. To hear more about how you can receive this and other Private Briefing investor reports, click here.

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