Japanese yen (FXY) traders have been here before. Earlier this year, the U.S. dollar (UUP) ripped from historic lows against the yen around 76 to a peak just above 84 in just six weeks. One catalyst I noted in late January was the apparent readiness of the Japanese to use their strong currency to increase overseas investments. I next pointed to the prospects of intervention (which has yet to occur), and Japan's first annual trade deficit in 30 years (see "U.S. Dollar Drops To Lowest Point Vs. Yen Since October's Intervention"). Fast forward to today, and the Japanese economy has now logged five straight months of declines in exports (in annual terms) and a trade deficit for the fourth month in a row. From Bloomberg:
"Japan's imports exceeded exports by 3.22 trillion yen ($40 billion) in the six months ended Sept. 30, the biggest trade deficit for a fiscal half-year period, according to Ministry of Finance data going back to 1979."
The Japanese economy appears to be heading back into recession. The likely winning party in next month's national elections has reiterated promises to force the Bank of Japan (BoJ) to print unlimited quantities of currency to reach an inflation target of 3%. Traders and investors are naturally worried about the prospect of the Bank of Japan losing its independence from the national government. According to Allan Meltzer, the author of three books covering the history of the Federal Reserve from 1913 to 1986, the inflation in the United States in the 1970s can be blamed in part on the Federal Reserve's cooperation in helping the Federal government finance its increased spending in the 1960s on war and social programs: "The Fed expanded the money supply enough to hold interest rates down so that the Federal Government could do the borrowing." (For more, see the interview on Econ Talk: "Meltzer on the Fed, Money, and Gold." Scroll or fast forward to 16:22 and 22:35, when Meltzer describes the tenure of then-Fed Chairman, William McChesney Martin, Jr., the Fed's longest-serving Chair).
So is this time different for the yen? It appears so.
"…option traders are paying record premiums to protect against further depreciation…Three-month options show a record premium for dollar calls, which grant the right to buy the U.S. currency against the yen, over puts, which confer the right to sell. The 25-delta risk reversal rate, which measures the difference between implied volatility on similar puts and calls, reached 0.945 percent on Nov. 15 and was at 0.935 percent today. That compares to an average of a 1.8 percent in favor of dollar puts since Bloomberg began collecting the data in 2003."
Bloomberg also notes that large traders like hedge funds have ramped up bets against the yen over the last four weeks: "So-called net shorts have averaged 31,442 contracts over that period, compared with average net longs of more than 18,000 in the prior four months, figures from the Washington-based Commodity Futures Trading Commission show."
The piling on against the yen is showing up clearly in the charts, as yen crosses have pressed extremes for over a week, hitting the upper part of what is called the Bollinger Band, which is a rough measure of the expected trading range based on recent volatility.
The U.S. dollar has rocketed higher against the yen since the September/October lows, and especially over the last week
This weekly chart is both a sobering reminder of the yen's dominating strength to date, and the potential upside opportunity in USD/JPY if this dynamic changes
Even the lowly euro has soared against the yen, and is now pressing against short-term trading extremes
The pound also just reached short-term extremes as part of an ongoing, rocky climb from 2012 lows set in January
Given these extremes, however, one should expect a pullback at any time. The currency market rarely tolerates such extremes for long. All one needs to do is look at the trading in USD/JPY in the earlier part of the year. I also am loathe to chase the yen here because odds favor some kind of headline, geopolitical event, etc. that creates enough of a temporary scare to get traders back into auto-response mode and scrambling for cover under blankets of yen paper.
Over the longer term, it seems the U.S. dollar will hold a sustained advantage over the Japanese yen. Despite the Federal Reserve's promise to print money as long as it takes to bring unemployment rates down, the U.S. has suddenly generated a tremendous advantage over Japan in energy costs. Part of what drove the U.S. dollar against the yen earlier this year was the realization that cheap natural gas would bring some manufacturing back into the U.S. and give companies a cost advantage. Last week, the International Energy Agency (IEA) predicted that the U.S. will become the world's largest producer of oil by 2020. Current U.S. oil production is already at a 15-year high. These milestones should solidify the U.S.'s energy cost advantage and give the country an additional leg up over Japan. Moreover, Japan's monstrous debt load will get harder and harder to maintain the longer trade deficits persist. So I am guessing that the Japanese yen will not retest historic highs against the U.S. dollar anytime soon, and the time is now to buy the dips in USD/JPY.
Even if next week's election somehow generates "yen relief," I think the increasing domestic anguish regarding the over-valued yen will sooner than later change the dynamic on the yen in a sustained way that will bias the currency toward weakness. (In perhaps a catch-22 for the yen, whenever global economic growth becomes robust again, the yen will stand out as an excellent candidate as a funding currency.)
Finally, if the yen does continue to weaken into 2013, buying shares of Japanese exporters may continue to make sense to the extent a weaker currency can deliver a better competitive position. At the beginning of this year, I suggested nibbling on Toyota (TM). It is now up about 18% since then, but it is currently below 52-week highs and remains trapped within a four-year trading range. A downward trend in the yen could translate into a breakout for exporting companies like Toyota.
Toyota still looking for a catalyst for a breakout
Source for charts: FreeStockCharts.com