On January 26, when the Yen was trading around JPY88/USD, we suggested the Yen at the 80 level was like gold at $147/ounce, i.e., on a pinnacle from which the only direction was down. Commodity guru Jim Rogers describes the USD and Yen rallies as "artificial" and the result of forced liquidations (of carry trades). UBS currency analysts in Tokyo have estimated that approximately JPY20 trillion of yen carry trades were unwound in the second half of 2008, and were a major factor in the yen’s spurt to the JPY88/USD level.
Since then, JPY has depreciated some 8% against USD to the JPY96/USD level, and investors/traders began to question just how safe a haven JPY could be if the economy is entering a near-depression state. Several Seeking Alpha contributors are also suggesting that JPY has further to weaken (Sean Hyman: “Be Prepared for a Weaker Yen”, Keith Fitz-Gerald:“Is the Yen as Safe as Everyone Thinks?")
The latest trade numbers were more evidence that Japan’s economy is in trouble, as exports fell 45.7% YoY after a record 35%-plus fall in December on approximate 50% YoY declines in essentially all regions, including China. As a result, Japan recorded its sixth consecutive month of trade deficits, while the plunge in exports is pointing to another month of deep production cuts (-30% YoY). Japan is expected to record its second year of negative growth in 2009, with a decline that could be as large as 5% YoY in real GDP terms. But the strong yen scenario was based more on a “balance sheet quality” approach, i.e., which countries are less likely to flood bond markets with sovereign debt to fund large economic stimulus packages? Or as FT Alphaville termed it, “buy yen, sell Japan”.
The 8% decline in JPY has come from only a relative slight decline in net long large speculator positions of 36,188 contracts, from a peak of 50,518 on February 3, 2009, when the yen hit JPY88/USD. This net long position has been built up since last August, when large speculators had a net yen short position of (23,138) contracts and JPY/USD was trading at the JPY110/USD level. Overall futures trading in JPY/USD as indicated by the open interest, is down substantially to 108,865 contracts from a high of 212,982 contracts on August 19, 2008. As the net commitment of traders is still long JPY, there appear to be lingering expectations of a renewed yen rally.
On the Tokyo Financial Futures Exchange, where Japanese individuals trade currencies on margin and are having an increasing impact on currency levels, USD/JPY forex margin contracts are back up to 53,018 from a recent low of 37,180 in January, but still well below a previous high of 87,053 contracts in January 2008. The yen’s sharp appreciation was painful for Japanese individuals who were betting against the yen by buying foreign currencies, but they appear to be coming back (i.e., re-establishing long non-yen positions).
What Do the Pros Think?
London-based Bank of Tokyo-Mitsubishi UFJ strategists see the yen weakening further as Japanese exports wane and investors are done paying back loans used to fund the so-called carry trade. To the Bank, it is clear that the very large yen carry position that had been built up primarily over the period between early 2005 and the onset of the financial crisis in August 2007 has now been fully unwound.
Currency traders used to focus on interest rate differentials between, for example, 10-year JGBs and 10-year TBs, particularly changes in these spreads. With the economic crisis, however, Fed Fund rates in the US and overnight call rates in Japan are bumping up against the zero rate horizon, which means interest rate differentials have become meaningless. As a result, some traders are starting to use sovereign credit default swap (CDS) prices as an indicator of currency direction. Since January 2008, the correlation between the yen and the cost of protecting against a default on Japanese government bonds swung to negative 43 percent, showing investor concerns about Japan’s economic health are increasing. The yen and cost of credit-default swaps moved in tandem 88 percent of the time last year.
Other pros however don’t buy the argument that CDS prices influence currency movements, saying that it is actually the other way around, i.e., that currency movements tell you what swap spreads are going to do. These traders nevertheless are now looking at sovereign swaps rates.
More recently, however (February 25), Bloomberg was reporting that the premium on USD puts over calls had shrunken to about 2%, which has happened only five times since July 2007. This technical indicator measures the price for the right to sell USD relative to the right to buy them. Traders point to this indicator as a signal the yen is set to re-surge to JPY85/USD, or 14-year highs. This is because the last time the premium on 1-month 25-delta USD puts (delta measures the change in an option’s value relative to moves in the underlying currencies) over calls approached 2%, the yen surged 21% from August 15 2008 to January 21, 2009.
However, this move coincided with the sharp reversal in the CFTC net JPY/USD positions by large speculators from a net short position of 23,138 contracts in the 8.19.08 week to a net long position of 50,518 contracts by 2.03.09, as well as a massive forced liquidation of yen carry trade positions.
Since the net long JPY/USD commitment of traders is still at a relatively high level, and assuming that the forced unwinding of yen carry trades has largely run its course because of better stability in the global financial markets, we suspect that a USD put/call premium will have nowhere near the punch on JPY/USD as much as it did between August 2008 and January 2009.
If this is the case, the yen is more likely to be trading under JPY/USD 100 in the next couple of months than JPY/USD 88 or higher, and the yen index ($XJY) will inevitably test 100 (its 40-week MA) at least once. To us, this means more downside on FXY.
Stock position: None.