Oppenheimer International Bond Fund has historically held around 15%-20% of its assets denominated in one of the largest currencies in the world, the Japanese yen. That shouldn’t be surprising, after all Japan is the second largest issuer of debt in the world, behind only the U.S.
But now we’ve cut the Fund’s yen exposure to almost zero.1 That’s right, the yen is the biggest weight in our stated benchmark index, and we have almost none of it2 and we plan on having none of it for a while. It is one of our highest conviction bets in the portfolio. The yen has been one of the biggest movers in the currency world this year, losing 3% of its value against the U.S. Dollar as of January 18, and weakening almost 15% since the end of September 2012 (see the chart below). In our mind’s the yen’s fall isn’t done, either, we think this is just the beginning of a longer, more significant structural trend of yen weakness.
As most international economic observers are aware, the Japanese economy has been stagnant for decades, with real GDP growth hovering around 0.8%/year3 over the last decade. Deflation, not inflation, has been Japan’s bigger problem, with the country’s consumer price index falling, on average 0.19%/year since 2002.4 The economy entered a recession in the second half of 2012, and the nation’s healthy positive current account balance is starting to deteriorate.
So why have we gotten out of the yen now?
In December, Japan’s electorate overwhelmingly voted for a new prime minister, Shinzo Abe, on a platform of implementing a new round of aggressive policy measures in order to jump-start Japan’s economy. Abe painted a big bulls-eye on the central bank, by asking voters to ratify his desire to demand a more assertive inflationary target of 2%/year. My colleague Krishna Memani gave his take on Japan shortly after the election.
Japan, unlike nearly every other major economy, did not embark on an aggressive, currency-debasing monetary or fiscal stimulus program during or after the global economic crisis. Indeed, investors flocked to the yen as a safe haven from 2007 until recently. The nation’s central bank, the Bank of Japan, hasn’t significantly expanded its balance sheet like the Federal Reserve, the UK’s Bank of England, or the European Central Bank have, either. The next chart makes it clear how Japan has lagged in that regard.
But, we expect that to change very soon. Indeed, thanks to the huge pressure from the government and the populace, the Japanese central bank “caved” in its January 22 meeting by adopting the higher 2% inflation target and opting to start an open-ended, 13 trillion yen asset purchase program (though indicating a delay until January 2014 to begin these additional purchases). While the Bank of Japan is clearly trying to hold on to its independence, it realizes it needs to act more aggressively and do its part to revive the economy.
Given constraints on the country’s monetary transmission mechanism, we think a weaker yen will be one of the primary valves for injecting some inflationary steam into the economy. The link between base money and CPI broke down in the 2000s, Japan’s credit channel has collapsed given the cash richness of companies and consumer, and the interest rate channel has been non-existent for years given nominal rates are close to zero. Several studies conservatively estimate that the yen would have to weaken at least to 100 yen/$1 in order to generate 2%/year inflation – we are at about 89 yen/$1 now. As other currency moves have shown us in the past few years, the central bank that most aggressively pursues quantitative easing wins by having the weaker currency.
In sum, most economic drivers of currencies are favoring a weaker yen, and both fiscal and monetary policies are set to change imminently to reinforce this trend. We still own Japanese debt, but we have hedged the currency exposure of our entire Japanese government bond position.
1 As of 12/31/12, Oppenheimer International Bond had 2% exposure to the Japanese yen. At 6/30/12 it was 15% and at 9/30/12 it was 8%.
2 As of 12/31/12, the Fund’s stated benchmark, the Citigroup Non-U.S. Dollar World Government Bond Index, had a 42% exposure to the yen. The index is an index of fixed rate government bonds with a maturity of one year or longer and amounts outstanding of at least U.S. $25 million. is unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any Oppenheimer fund.
3Source: International Monetary Fund, World Economic Outlook as of 10/31/2012. Data is most recent available.
4Source: International Monetary Fund, World Economic Outlook as of 10/31/2012. Data is most recent available.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and political and economic uncertainties. Emerging and developing market investments may be especially volatile. Fixed income investing entails credit risks and interest rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall.