Incoming Japanese Prime Minister Shinzo Abe's demands for open-ended central bank easing have seen the yen down over 5 percent against the U.S. dollar since mid-November. Abe and his supporters, including the influential Chamber of Commerce and Industry, insist that the Bank of Japan (BOJ) is doing too little to end Japan's crippling deflation. In the past decade, consumer prices excluding food have fallen on average 0.2 percent monthly. Weak demand from the EU and China has driven exports lower for six consecutive months. His solution to reviving Japan's export-driven economy is simple: devalue the yen.
He warned that unless the BOJ raises its inflation target to 2 percent at its January meeting, the bank's charter would be revised to accommodate the parliament's will. Despite the latest expansion by the BOJ in asset-purchases, Governor Masaaki Shirakawa declined to double the central bank's 1 percent inflation target. Shirakawa is set to step down in April, and Abe's government is expected to appoint a more accommodative governor. Two deputy governors will end their terms in March and already two new members of the policy board have pressed for increased inflation.
Governor Shirakawa was careful to note that the BOJ will not directly finance public debt, stating that the government "will not efficiently recognize the size of its debt" if it becomes reliant on central bank largess. It is critical for Japan to maintain at least a semblance of stability unless investors view excessive inflationary policies as a monetization of Japan's staggering debt load. The risk of bond-yield spikes and potential downgrades would make interest payments on debt unmanageable. The BOJ revealed recently that its sum of Japanese government bonds passed the 100-trillion yen mark for the first time. After expanding its asset purchase program for the fifth time this year and with worse data to show, Shirakawa must be weary of the efforts. He already had concluded in 2002 that "in a situation where there is little room for a further decline in short-term interest rates, the effects of monetary easing will necessarily be limited."
Demonstrating its limited range of action, the BOJ even considered scrapping the 0.1 percent interest paid on lenders' deposits in an attempt to weaken the yen further. While Shirakawa and his dwindling allies managed to reject the proposal, the composition of the BOJ's policy board is transforming and likely to reflect the wishes of Abe. Direction from Abe, who was described after his previous administration as "unable to impose discipline upon a cabinet of the corrupt and incompetent," would, in a vacuum, imply an increasingly weaker yen. But Abe himself telegraphed the risks of this trade. He pressed the BOJ to resist action by the other influential central banks, notably the Federal Reserve, to devalue their own currencies.
The Federal Reserve won't be under Abe's direction, and it will continue to buy bonds. In fact, the Fed, the European Central Bank and the Bank of England are more likely to embark on asset purchases as a devalued yen strengthens their currencies. As rhetoric of "currency wars" could escalate in Japan, as elsewhere, it is important to note that devaluation tends not to be unilateral. If countering moves interrupt his plans for the yen, Abe would predictably deflect blame to the Fed, ECB or BOE, allowing him some political cover. In this type of environment, the substantial short interest in the yen could see massive squeezes from central bank retaliation elsewhere.
With Abe at the controls, a much worse scenario would be possible for Japan if, like he wishes, the other central banks do not react. With interest rates near zero and already having unleashed countless rounds of limited QE, the Abe camp would seemingly press for much more expansive purchases than previously, perhaps according to the recommendations of Paul Krugman. The following chart of central bank assets as a percentage of GDP (as of June), shows that the BOJ's balance has not yet expanded to the extent of the others.
For Japan, easing on a scale equal to the other banks, given its debt-to-GDP ratio, runs the risk of it being perceived as monetizing its debt. Interest rates would drive up faster than tax revenues and terms like "default" and "hyperinflation" would become common parlance. There is no bailout for Japan.
For those who chose to speculate on the developments regarding Japan, short positions on Japanese Yen Trust (FXY) should be tempered with the expectation of action by other central banks resulting in short squeezes. Long positions in the much more liquid MSCI Japan Index (EWJ) can also be employed in the same way, but with provisions for long squeezes. A consistent inverse correlation between FXY and EWJ should not be assumed. For those comfortable with individual stocks, there is the Tokyo-based financial Nomura Holdings (NMR), which reacted extremely well toward the prospect of an Abe super-easing. Unfortunately for options traders, contracts on this stock have slight open interest and large spreads.
While the potential for continued depreciation of the yen is exciting to many investors, the consequences of huge short interest running for the exits should be weighed. In this world of expanding central bank balance sheets, there is no telling who will up the ante next.