Wednesday 9 January 2013

A Brief Note on the Yen

We’re currently busy writing our second post, which will focus on the Japanese Yen. We can by no means be certain that the recent bout of selling has exhausted itself, but as we’ve stated we like to establish a position when we think that the long term potential of the trade trumps its short-term risks. Hence we’re buyers here. As to why this is the case, please find below a brief summary of the salient points, on which we’ll elaborate further during the course of our next post, which we expect to go live early next week.

Interesting Fundamentals

Inflation as properly defined (an increase in the supply of money and money substitutes) has been relatively tame in Japan, particularly when compared to the rates of growth achieved by the Federal Reserve and the ECB. This gives our bullishness a solid basis, at least until the Bank of Japan continues to refrain from implementing the “bold” (read reckless and ruinous) policies invoked by Abe (our contention, backed by actual facts, is that so far nothing meaningful has really happened: traders just think it has). When it comes to the next BoJ Monetary Policy Meeting, it seems to us that the market has likely discounted at least both an increase in the size of the asset-purchase program and the adoption of a 2% “inflation” (we use the term here in its common fallacious meaning) target. Imagine what could happen if they were going to disappoint… Even if the BoJ were to implement both, we think we could still witness a “sell the news” event. As for the long-term soundness of the trade, it’d need to be re-evaluated in light of the Meeting’s decisions, keeping in mind that one thing is to “adopt a 2% inflation target”  and another one is to actively print money at a high enough rate to achieve the Yen’s devaluation (keep in mind that it’s not so easy to outprint Bernanke). Moreover, we harbour more than a few doubts about the desirability of a weakening Yen (and the accompanying rising interest rates) and we suspect that these are shared by quite a few Japanese, including some powerful business leaders who could make their voices heard at the LDP’s headquarters (the fact is, if Abe is not a complete fool, like for example Hollande is, he’ll quickly reach the same conclusion without the need for any outside help).

Two different and somewhat interrelated catalysts

We suspect that in recent times there has been a resurgence of the infamous carry-trade, particularly in favour of what we like to call bubble currencies (the Aussie dollar is chief amongst them). This has likely been driven by the desperate and very risky hunt for yield, which has also produced the already mentioned collapse in the spread of risky bonds vs. treasuries [Ed. Note: we can personally attest to this fact, as we’ve witnessed many European banks peddle Aussie bonds of questionable quality to unsuspecting customers. This is moreover confirmed by the worryingly high 80% of Australian government bonds and 70% of corporate bonds currently owned by foreigners.].
The Japanese hold a massive 3.3 trillion $ in net overseas assets (of which roughly 1.3 trillion $ are foreign exchange reserves, whilst the rest is in the hands of the private sector), more than 50% of their annual GDP. What if they suddenly repatriate some of them (maybe because of a scary bear market in equities or a resurgence of the European debt crisis or a deepening recession at home)? We mention here en passant that Japanese holdings of Australian and New Zealand bonds are rather large in both absolute and relative terms. This, coupled with the very real possibility of a sudden bursting of the Australian bubble and a few other considerations, makes us think that the best way to play the Yen is via the AUD/JPY and NZD/JPY crosses. A careful accumulation of long-dated put options might prove to be a savvy speculation, as they could allow the owner to withstand any further upside there might be left in these crosses whilst at the same time limiting his losses to a predetermined amount in case the BoJ really goes nuclear.

Extremely oversold readings and one-sided Sentiment

The USD/JPY cross has not been so stretched above its 200-day simple moving average since at least 2005. This combines with many other measures and indicators into an extreme technical picture rarely seen and almost always destined to revert spectacularly. Countless pundits and self-appointed experts with a dubious track-record have been all over the news predicting nothing less than the total collapse of the Yen. Sentiment on the currency lies at multi-year (probably all-time) lows. There are also signs that Japanese investors have recently increased their exposure to foreign equities (mainly American ones): as they tend to be rather risk-averse, this may indicate an extreme degree of complacency in the markets and act as a contrary signal for stocks (reference our post on equities as well), which could in turn activate on of our hypothesized catalysts.

How Bull Markets end

We will also go through a brief list of the phenomena that usually accompany the end of secular bull runs, with the purpose of showing that none of them are currently present in this case. We’ll use Apple as a recent example of how such moves tend to end (although it’s important to note that not all of them reach the same mind-boggling extremes).

Conclusion

We are bullish on the Yen and we’re actively buying it. We cannot rule out further weakness (and in particular a test of the 90 zone against the USD), but we consider the risk/reward proposition to be good enough for us. Readers should always remember the importance of doing their own analysis and of proper position sizing and risk management strategies.

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