After several attempts by the Japanese government to shock its currency out of a deflationary tailspin, the international monetary system is finally ready for a weaker Yen. This time is different. And not just because the Japanese Vice Minister of Finance Takehiko Nakao said so. Not even because Prime Minister Shinzo Abe said so. For the last two decades, Japan has faced a unique combination of economic and political obstacles that it has historically been poorly positioned to confront. Previous administrations have lacked the political impetus, the BoJ to resolve, to effectively combat the economic pressures which have plagued the nation and their currency. There is evidence to suggest, however, that the newly elected Shinzo Abe and his "cabinet of radical nationalists" just might get the job done.
The focus of this piece is the Yen trade. Specifically, the short-yen-against-anything-not-nailed-to-the-floor trade that has been FX position de jour for the last 3 months. As of current, technicals indicate that the currency is oversold, the Nikkei is overbought, and both markets are due for a few nasty corrections before it's said and done. I don't disagree, but remain strongly bearish Yen (and by extension bullish on the Nikkei, at least in the short run). I'm targeting north of 100 (USDJPY) by year end and would advise anyone to do the same. The easy part of this trade is over but that doesn't mean there isn't still money to be made. First, some charts:
USDJPY 5M chart shows bearish consolidation.
The Nikkei and USDJPY graphed side by side since the middle of October.
USDJPY chart from the December election to current. Notice the trend towards greater and greater oscillations within the ascending channel.
Now, let's back up and talk fundamentals for a moment. If you're not in the mood for an abbreviated economic history of Japan skip the next section, but I think it's important to contextualize this most recent attempt to escape deflation.
A Brief History of the Yen: The chronic deflation that has persisted through Japan's Lost Decade and beyond has been a function of both global and domestic economic pressures. For the last 20 years, any inflationary force exerted by the Bank of Japan's on again - off again easing and near-zero interest rates has been overshadowed by a constrained financial sector, ailing domestic industries, and an unwavering demand for Yen by international investors. Because of its unique position as the most stable Asian G20 nation, Japan has continued to be perceived as a safe-haven for financial assets despite their economic woes. The perpetual strengthening of the Yen has had several tertiary consequences which have at best distorted markets and at worst deterred constructive foreign investment, reinforcing the deflationary cycle. The trade deficit (which just recently hit a record low of USD 78 bn in Dec 2012) is both a function and a symptom of a strong Yen; the same foreign demand which allowed for such rapid growth throughout the latter half of the 20th century proved to be too much of a good thing in the 90s. As the Yen has strengthened, it has become increasingly difficult for exporters to compete in traditionally strong industries (tech, auto) as exporters' margins are pushed near nil. The resulting pressure on total output has helped move GDP growth into negative territory in recent years.
The last half of the 20th century actually wasn't all that bad for Japan. In fact, with aid from the U.S. and their allies, the nation saw some of the largest year-over-year growth in the developed world (avg. 6.15% annual increase in GDP from 1950 - 1990). It eventually attained the third largest GNP behind the United States and Soviet Union at its peak. In 1988, after 40 years of economic growth, Japanese leaders decided that easing of monetary policy would be in Japan's best interest. Around the same time (1985) the U.S. and Japan signed the Plaza Accord in which officials vowed to depreciate the Dollar explicitly against the Yen (after a 50% appreciation vs. G10 currencies the previous decade). The rapid expansion of the 70s and 80s gave way to a supply glut (especially in the real estate and industrial sectors) and weakening domestic demand in the early 90s. The problem was compounded by a lack of credit, which was itself a function of a cultural stigma against debt and fundamental mistrust of the banking system. Nobel-winning economist Paul Krugman has described Japan's Lost Decade as a 'liquidity trap' (too much saving) while economist Richard Koo has called it a 'balance sheet recession' (constrained credit). Both descriptions attempt to explain the underlying phenomenon in which Japanese banks and corporations abruptly stopped lending and borrowing money. Instead of attempting to weather the storm and grow their way out of debt, companies used all available cash flows to pay back what they owed. The recession may be best characterized as a period of prolonged deleveraging on a massive scale. The only growth that occurred was a direct result of increased government spending, which came at the expense of today's massive deficit.
Japanese economic policy has attempted to resolve the deflationary issues facing the nation several times throughout the last twenty years, first with a series of bank bailouts and later with intermittent fiscal stimulus. Neither method was particularly successful, though Keynesians (of which Krugman is the loudest) have argued that measures were simply not extreme enough. Average GDP growth in Japan has been a meager .8% since 1991. In recent years, the nation's problems have been compounded by natural disaster and not unrelated political discontinuity.
This Time is Different: That brings us to Abe version 2.0. The newly elected former prime minister has promised to devalue the Yen by any means necessary, even going as far as threatening to alter the Bank of Japan's charter if it does not fall in line. Keep in mind that the BoJ has only been a fully autonomous technocratic institution since 1997. While extreme, Abe's threat is much more credible than, say, Ron Paul threatening to dismantle the Fed. The proposed medicine for the economy, now fully apparent following last week's BoJ minutes, is fiscal stimulus, monetary easing via "unlimited" GJB purchases, maintained low interest rates, and (apparently) sustained, overbearingly dovish rhetoric from Tokyo. In other words: the same Keynesian policies that they've been unsuccessfully attempted for years, but in higher dosage, and all at once.
In addition to the magnitude of Tokyo's effort, there are several factors conspiring to help the Abe administration lift USDJPY out of double digits.
1. The Current Account: Japan is fast approaching an impasse regarding its trade deficit. Constraints on the energy sector following the 2008 earthquake have forced Japan to import an increasing amount of energy from abroad to replace the nuclear power that previously supplied roughly 35% of the nation's electricity. Additional downward pressure on the trade balance comes from escalating tension with China. In 2011, Japan posted its first trade deficit in 20 years and if the trend continues, the nation will move from a trade deficit to a current account deficit, a change which would all but force a reevaluation of Japan's credit rating. A nudge downward would bump borrowing rates and put pressure on the already large fiscal deficit. It is important to remember that one of the primary reasons that Japan has been able to borrow over two times its annual output is that it has, for years, and years, and years, run a current account surplus. A move into negative territory for Japan's balance of payments would be an incredibly bearish signal in and of itself, to say nothing of the problematic implications of a shift from domestic to foreign debt holders.
2. Bottoming Rates: After a 30 year rally throughout most of the developed world (let's just forget about the southern half of Europe for a moment), interest rates are finally just about as low as they can go. I'm not contending that they will rise anytime soon - that's the subject of someone else's dissertation - but they will not go much lower and that is a big deal. As the search for yield continues investors will, if they haven't already, begin to anticipate rising rate environment. In this context, there may emerge a bias towards those countries whose short rates are likely to sell off and so long as the LDP drive to devaluation is intact, Japan is very obviously not one of them. On the other hand, an actual increase in yields abroad (and especially in the U.S.) would draw money out of the Yen and remove some of the fundamental demand that has supported the currency for the last two decades. Either by active replacement or passive reinvestment of funds, it is reasonable to expect flows out of Yen as it begins to look less attractive relative to its safe-haven peers.
3. Politics as Usual: Finally, and I believe this is the downside risk not yet appropriately priced, there are political pressures that are not well understood by foreign investors. In any American election there are analysts who make their living researching candidates' largest contributors, corporate ties, and the likely economic winners of electoral outcomes. The relationship between Tokyo and Japanese industry is no different, but for some reason it seems that much of the analysis has been lost in translation. That is unfortunate because it is directly relevant to Abe's resolve vis-a-vis the future of the Yen. By understanding why the Liberal Democratic Party has spent the last three years criticizing the BoJ and "weak" fiscal policy, we might better understand how the party is most likely to react in any number of scenarios.
Abe's Liberal Democratic Party has held both the prime minister and control of the Diet for all but 3 of the last 60 years. As such, though the new administration has exhibited certain characteristics divergent from past LDP coalitions (they are strongly, perhaps militantly nationalistic and have already exhibited a disregard for the regional diplomacy which highlighted Abe's otherwise abysmal first term in office), it is apparent that strongly entrenched interest groups are likely to continue to influence the direction of economic policy. Take a look at the Jan. 1 WSJ article Japan Big Business Sees Hope in Abe for a thorough overview. Without getting into the Japanese concept of Keiretsu (locally based, politically organized, financially focused industrial networks), it is important to understand that the LDP has historically had strong relationships with the troubled energy and industrial sectors. Abe in particular is well known to have close ties to the energy and shipping industries. According to Japanese entrepreneur Seiji Mutou, "Mr. Abe has an extensive pipeline to corporate Japan." Another source, Toyota Motor Corporation president Akio Toyoda, said that Japanese big business has "high hopes" for the new Abe administration. The implications are clear: economic stimulus will be prioritized over social issues, and probably even over non-trade related foreign policy. There is anecdotal evidence of this already happening: Japan's Minister of Welfare just announced that they will begin cutting state welfare benefits by 6.5% across the board in an attempt to root out the "comfortably poor."
Abe understands that he has been blessed with a second chance. I anticipate that he will move quickly and boldly to embrace the opportunity.
Checkpoints: There will be several checkpoints this year that will provide confirmation as to the efficacy of Abe's policies. In April BoJ Governor Masaaki Shirakawa's term will come to an end. Abe will seek to replace him with the most compliant and dovish candidate possible. He should have no trouble getting approval of the House of Representatives; the House of Councilors where the DPJ does not yet hold a majority will be the only real obstacle. Current opposition leader and DPJ successor to Yoshihiko Noda has said that the new BoJ governor should not simply be Abe's "yes man." He also, in the same breath, expressed a strong desire to avoid any legislative conflicts - a similar debate left Japan's central bank governor-less for 20 days prior to Masaaki Shirakawa's appointment five years ago. Ultimately, following their shellacking in the December elections, the DPJ opposition does not possess the political capital to put up much of a fight.
In July, elections will be held for the House of Councilors. The implications of a LDP win are important for several reasons. First, they will serve as a real-time measure of public support for Abe's policies thus far. An LDP sweep of both the December and July elections would indicate a return of national consensus of sentiment that has been absent in recent years. In a representative democracy with such a high turnover (the average term for a Japanese prime minister is just 2.1 years since 1945) this will tell us much about the potential longevity of devaluation policies. Additionally, unilaterally controlled LDP central government would greatly expedite the devaluation process by eliminating Abe's only current obstacle.
The 2013 G20 Summit in Moscow (Sept. 5 - 6) will provide continuing insight into Japan's dedication to deflation as it faces mounting international political pressure. Several leaders have already accused Japan of instigating a currency war and though both Bernanke and the Bank of Canada's Carney have said that they do not believe the international system is to that point yet, another 8 months of a weakening Yen has the potential to escalate tensions significantly. Assuming that the pieces fall into place throughout the spring and summer, the G20 meeting may prove to be the best litmus test for the longevity not only of a weaker currency, but also of the Abe administration.
...And the trade: Obviously there are a number of ways to get Yen exposure. ETFs are one possibility. JYN and FXY each offer direct exposure to the Yen on a 1:1 basis. YCS and YCL are double-levered (short and long, respectively) Yen USDJPY tracking funds. I propose three separate trades offering three distinct risk / return profiles:
1. Going naked short JPY against a basket of G10 currencies is the simplest, most straightforward trade. With the Yen currently trading around 90.00 vs. USD, the return at 100 USDJPY is a respectable 11%. Potential losses in EUR and CAD should be more than offset by moderate strengthening in CHF and GBP. While the upside in this trade is constrained by global economic factors, volatility is greatly reduced. For those looking for ETFs to trade, FXY, which tracks USDJPY, is the best bet. A variant of this trade would be short Yen vs. EM. No doubt, long MXNJPY would have been a fantastic trade last September, but in my opinion the Peso is currently slightly overbought. Nevertheless, emerging markets have performed admirably in the past few months. Long EM vs. Yen is an interesting strategy for those who believe 2013 will be risk on as Europe continues to improve and tail risk continues to diminish.
2. The levered ETF trade is perhaps the most attractive in terms of risk / reward profile. Long YCS is obviously preferable to going short YCL due to cost of carry and more sophisticated investors might even look at hedging the trade with USDJPY puts.
3. Finally, whether you agree with my analysis of the current politico-economic environment in Japan, it is difficult to argue that 90.00 USDJPY is not a sustainable price level. Japan's trade partners want the Yen back down at 85 or lower while the Abe administration is targeting 100. A long straddle would provide upside in both scenarios while minimizing balance sheet exposure. The only potential issue with this strategy is the time frame; I believe it is possible for this trade to take a few months to work, which would necessitate using fairly long-dated options. Losses taken on theta may eat well into potential profits.
Wrapping Up: I said that this time was different (and it is), but that does not mean that all is well in the land of the rising sun. If the Abe administration gets its inflationary wish, Japan will be forced to contend with rising borrowing costs which would make their precarious debt situation less sustainable. The idea of Japan growing its way out of debt is already laughable and unless a weakening currency affords the nation a massive boost in exports, it is hard to foresee a circumstance in which Japan could raise enough revenue to make the current debt sustainable in a higher rate environment. The timing couldn't be worse: policy makers will grapple with either deflation or deficit (pick your poison) from atop a demographic time bomb ticking closer and closer to zero. And this is their last bullet. Probably. It is unfathomable, at least to this author, that Japan could sustain another significant debt increase without serious skepticism and even a potential credit downgrade, which would result in the aforementioned problems without any of the economic benefits. They're damned if they do and damned if they don't, but after 20 years of stagnation, at least they're trying something.