Last week we reflected on what lessons, if any, the Japanese experience with deflation carries for gold investors elsewhere. A tentative conclusion was that the value of Japanese Yen mattered probably more for Japanese gold investors than the domestic decline in prices. And while the recurrent deflation has certainly influenced the wide-spread preference for long-term holdings of JGBs, the evidence for gold has to be sought in more selective statistics of bar hoarding, coin purchases and gold accumulation plans. A look into these historical data reveals just how astute the daily readers of Nikkei Shimbun are…

Let us step back to the onset of the first yen-carry trade, in 1996. After a record year for gold investment in Japan (1995 was punctuated by the Kobe earthquake and 18-year low prices in JPY terms) the investment demand nearly halved to 57t. The following two years saw a combination of profit taking and bursts of demand towards the end of each calendar year. In 1999, the Yen strengthened and deflation began, but overseas gold also hit a low of $275/oz. Investment demand in Japan picked up 16%, but this was a short-lived phenomenon, despite deepening deflation and further strength in the Yen.

Carry trades resumed in 2001. Between terrorism, Argentina’s default, Enron and a collapse of Daiei supermarket chain, Japanese investors increased somewhat the purchase of gold for investment purposes (this was the time when yellow jewelry barely sold in Japan). In early 2002 – against the background of weakening Yen and stronger gold prices, Mrs Watanabe rushed to purchase gold to protect the household against reduced government insurance for time deposits. Investment in gold hit 95t – an amount never registered again. At that time, bullion would change hands at around Y1400/g.

The subsequent three years of deflation saw a recovering economy, buoyed by exports and aggressive (and ultimately futile) attempts to weaken the Yen. Interest in gold depended on a variety of factors, ranging from the health of the banking sector, the performance of the local stock market and the JPY exchange rates.

The shock came in 2006, after the deflationary period was over. The carry-trade driven depreciation of the Yen sent the prices fast above Y1500/g and Mrs Watanabe began to take profits. That year, the Japanese disinvested a net amount of nearly 43t. With equally weak Yen the year later – and gold continuing to gain strength (crossing Y2600/g), 2007 saw a further 32% growth in net disinvestment. This process continued until JPY reversed the course in the wake of Lehman’s collapse towards the end of 2008. The return of deflation and a stronger Yen (a veritable ‘Hauch des Lebens’ for the otherwise embattled uncovered interest rate parity) coincided in 2009 with further dishoarding, albeit at a much slower pace.

This short summary of the recent history in Japanese gold investment reveals Mrs Watanabe’s uncanny sensitivity to the fluctuations of real values (rather than nominal prices). It is all the more surprising because it is, a priori, impossible to gauge the exchange rate reaction to changes in monetary aggregates. For example, a reduction in money supply should, ceteris paribus, lead to an increase in nominal exchange rates – and (depending on interest rates) a possible increase in real exchange rates. However, as the velocity of money is reduced, deflation sets in, and deflation means a decrease in real exchange rates.

Despite the multifactor complexity of these phenomena, the wisdom of (ageing) Japanese crowds got it right. Naturally, the gold investment demand exhibited a very high (negative) correlation to gold prices expressed in Japanese Yen (based on annual average prices). No surprises here. However, given gold’s relentless gains during the last decade, the nominal exchange rate (JPY/USD as a proxy) offers little guidance (barely 34% correlation to gold prices in Japanese Yen). The value of the Japanese Yen vs USD does not correlate with the gold investment demand in Japan at all.

It is by looking at JP Morgan’s broad Yen index (real effective exchange rate), that an astonishing picture unfolds. First, gold confirms its role as a “reality” check on the actual value of the currency (an argument made on these pages previously). JP Morgan’s JPY index and gold in JPY correlate at 55%. And Mrs Watanabe beats even that. Her gold purchases since 1996 correlated at 63% with the real effective value of the Japanese currency!

More granular data (e.g. on a quarterly basis) would be necessary to refute alternative hypotheses. Yet even at this high-level, the short review illustrates how attuned Japanese investors are to the real purchasing power of their currency. Rather than offloading gold at the first sight of positive real interest rates, they continued to hoard the metal and then sold a third of these holdings once the economy crept out of deflation. Remarkably, latent inflation fears never dented their resolve.

Watanabe-san! Atama ga sagarimasu!

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Tags: deflation and gold, exchange rates and gold, gold demand in Japan, Japanese gold investment, real and nominal values