Reflexive processes are rare and far between in the financial markets, as Soros said. Abenomics is presenting just such a trading opportunity:
Act I: establish Yen shorts as Abenomics gains momentum
Act II: switch to JGB shorts when Yen undershoots, whether policy succeeds or not.
Not dependent on the success of Abenomics policy, the trade is betting on the market dynamics it drives.
The Abenomic Plan
Wikipedia provides a very good summary of Abenomics.
The gist (Chart 1) is stimulating the depressed aggregate demand through lower real yields and yen. Given zero interest rates, the key is to manipulate inflation expectation and a weak yen plays a critical role. The reflexive potential is apparent here.
Yen is the reflexive engine above and we focus on shorting yen in the first phase of the trading. There are good reasons to doubt the end result of Abenomics, but few to bet against its momentum and intermediate impacts: lower yen and stable JGB yields.
After two lost decades and failed experiments, conservatives are replaced by the radicals. Second chance is a rare commodity in politics and Abe's LDP is determined to make the most of it. Finally the long-resisted unconventional methods are taking over (see NBER paper).
We can expect Abenomics to gain momentum in the foreseeable future. Firstly, the market reactions have been favorable since launch-Nikkei rallied hard and yen slumped. As the NBER paper argues, the depreciating currency indicates policy effectiveness in manipulating inflation expectations higher. The reflexive cycle is off to a good start.
Too late to join the game? Deeper studies would conclude the game is just getting started. Policy success hinges on credibility, and credibility requires real commitments. When deflation expectation is entrenched (Chart 2), policy overkill is a necessary evil. To borrow from Nobel winner Krugman, BoJ should "credibly promise to be irresponsible".
Overkill necessitates more than an inexpensive yen (see real-time PPP). This fits the typical valuation cycles: currencies tend to move between extremes on the valuation spectrum, and rarely stop at fair values. As a rough guide, 20% undervaluation points to a policy target of 120 for USD/JPY.
Regarding trading risks, first and foremost is yen strength. The Japanese have the will and means to cheapen yen, but currency war is a real worry, esp. with the Fed or ECB. However, ECB is less a concern because it needs a strong euro to hold the EU project together. More importantly, rather than dumping yen outright the Japanese authority were actually learning from the masters on crisis management (Chart 3 and 4). That explains the remarkable restraint shown at recent G7 exchanges.
Another factor is JGB-without stable yields, higher inflation alone can't stimulate. The JGB bubble topic surely deserves another thesis and the current market consensus seems to consider it a longer-term challenge, which goes beyond the trading horizon in Act I.
Risk management: past experiments have shown policy indecisiveness leads to failures. It is strategic to build credibility by manufacturing a steadily falling yen without major reversals or volatilities. Otherwise, the reflexive engine lacks fuel and our bet is off. Therefore, exit the short yen position if USD/JPY drops below 5% from the local peak; update local peak (currently 94.32) and stop-loss (currently 89.60) if USD/JPY continues to climb.
Things are more path-dependent in this second phase of action. However, a short JGB position is worth considering across different scenarios.
Scenario One: Abenomics exit
In this benign scenario, Abenomics succeeds and needs an exit. The reflexive process is put in reverse (Chart 5). Breaking out of the deflation spiral, the economy will sustain itself on its own momentum and can afford the resultant normalizing yields. Sufficient yields are desirable to entice investors and make room for future easing during cyclical downturns. So this reverse cycle features a stronger yen and higher JGB yields.
Scenario Two: Abenomics fails
In the pessimistic case (Chart 6), Japan will plunge back into the liquidity trap. Crucially with policymakers having exhausted their ammunitions the market will completely lose confidence. The long-term structural challenges will increasingly turn into real-time pressures and the JGB bears will come back with a vengeance.
Timing the switch: naturally, we can make the switch when yen indeed undershoots (say, USD/JPY above 120). An alternative signpost to watch is inflation expectation as shown in Chart 2. Persistent and decisively positive (successful reflation) or negative (deflation return) readings can trigger the first shot at JGB.
Risk management: given the zero lower bound for interest rates, the payoff profile for shorting JGB at near-zero levels is asymmetric. Once the policy rate-cap starts to crack, the yields will press higher through another reflexive process, benign or malign. Once lifted away from ground zero, the risk control should be tightened.
A final note on Nikkei
The trade has not involved Japanese stocks. For Act II, the two scenarios have opposite implications for Nikkei. Given the tight correlation with yen, one might consider buying stocks instead for Act I since the upside seems more open-ended.
However, there are counter-considerations. If the tight correlation persists, risk-adjusted returns are similar and absolute returns are comparable when trading on the same risk budget. More likely, the correlation will fluctuate depending on the non-Abenomics drivers, which are beyond the scope of this thesis.
Since yen is the main control variable under Abenomics, Nikkei seems more of a derivative trade with no obvious advantage. Moreover, while an undershot yen is a policy goal, the authority has no similar ambitious plan for an overshot Nikkei though they certainly take comfort in market confidence expressed through stock rallies. Essentially, the yen short hinges on policy determination whereas the Nikkei long on policy success. This thesis is confident about the former but unsure about the latter.
Finally, learning from history, the FDR New Deal produced a more dramatic decline in dollar than a rally in stocks on a risk-adjusted basis (chart 7). This might be a relevant observation for our trading vehicle selection as well.