Between the day-to-day hustle of senior aides close to [Japanese Prime Minister Shinzo] Abe claiming "yen to be fairly valued" or "BoJ has further easing options", the cacophony of voices claiming the yen's sharp devaluation will lead to a repeat of the 1997 Asian Financial Crisis, or doomsayers pointing out that a rise in nominal interest rates will create a fiscal crisis in Japan or our favorite bear Kyle Bass's contention that Japan is on the road to an implosion from debt, it is very easy to get confused. What the heck is going on?
The more closely you follow the situation, the more noise clutters your vision. Debates about issues such as changing the central bank law, foreign bond purchases, etc. hit the headlines all the time, though they are forgotten equally fast.
In his article, I'll try to take a big picture view of (hopefully) the more salient points in the whole Japanese yen devaluation process. The every day noise might provide good opportunities to increase or decrease positions, but I will try to provide here my general idea of where the whole thing is going.
First Stage: Japan moves, market doubts
For some reasons (which are not the main focus here), in the last few months of 2012, Japan got the political will to start depreciating the yen (FXY). Market participants and academics doubted the BoJ/Japan's will to carry out new measures. Those that conceded the BoJ had the will, doubted it would be effective.
The academics that doubted the effectiveness of the BoJ's actions were largely thinking in the old paradigm where currency interventions were thought to be proven useless. This free market doctrine is more of a social norm, i.e. nations shouldn't engage in currency devaluation through overt currency printing in case competitive devaluation occurs like in the Great Depression, therefore such actions should be stigmatized so they do not occur in the first place. There is no actual logical basis in the conviction many academics had that the BoJ's actions would be ineffective: if a nation prints as much money as needed to push down the exchange rate, of course it'll work, it's just been discouraged and stigmatized so much that it sounds "wrong" (example here).
But this masks the essence of the first stage: participants' perceptions are smashed hard enough for the Japanese yen to lose the unconditional, knee-jerk safe haven asset recognition. This was enough to send the USDJPY from 78 to 90~100. Now participants have learned that the yen doesn't just keep going up, sprinkled with spikes from ineffectual interventions. The yen can actually be in a sustained downtrend for six months. Lesson: Don't buy the yen on a knee-jerk reaction anymore.
So in the first stage: the safe-haven allure is lost and the yen has adjusted accordingly.
Second Stage: Market doubts, Japan doesn't move
However, the doubts harbored by the market have a strong basis in fact. If nominal interest rates rise, funding costs for the national debt rise accordingly, and every 1% increase in funding costs is equal to 25% of fiscal revenue. With CPI slightly below 0%, if the BoJ hits its proclaimed target of 2%, assuming nominal rates increase by 2% as well, this will take up 50% of fiscal revenues.
Though higher inflation would erode away the national debt gradually, the short-term fiscal impact would be disastrous. How would the government fund itself if all of its revenue went to paying interest on the national debt? JGBs are mostly owned by Japanese banks, insurance companies and pension funds. A large decline in the price of JGBs would probably create large losses for these institutions. How would they cope?
This scenario seems so nonsensical that once market participants fully realize the implications of 2% CPI in Japan, they'll expect Japan not to take any further drastic easing measures. And they are probably right. Japan will not do more than is enough to keep the yen at reasonable levels and occasionally scare off speculators. As long as the BoJ can 1) keep people guessing on when it will move and 2) get enough people betting on trend continuation and selling the bounces, it can keep speculators at check with relatively low costs.
Ironically, it is often missed that before the qualitative and quantitative massive easing commitment made on April 3, Abe said that the 2 per cent inflation target he "imposed on the Bank of Japan may not be reached within two years." Perhaps Abe was winking at people who read between the lines that the commitment was mostly a tool to whack the yen bulls.
So in the second stage: participants realize the BoJ's promised land that devalued the yen is actually a disaster if Japan gets there, voiding the whole thesis of the BoJ's actions. The USD/JPY turns into a cat-and-mouse game between BoJ and yen bulls. However, the economic gain from a more reasonably priced yen is real and Japan enjoys the benefits.
Third Stage: U.S. rates rise, yen goes into free fall
Though the U.S. appears to be stuck in QE forever, the costs of more QE are drawing more attention. The banking system is slowly earning more money and purging bad loans. The housing surplus is getting slowly digested. It is not inconceivable that at some point, QE ends either due to an improved economy or the costs getting too big. U.S. nominal rates rise eventually and the USDJPY carry trade comes back into vogue.
In the Third Stage: we get back to the go-go years, time to pile on the leverage and use the yen as a funding currency. What? Japan CPI only hits 1.5% in 2016, and slumps back to 0.5% shortly after (Kuroda: Well my goal was never 2% CPI forever more, I never said it wasn't a one-time target...)? What does that have to do with anything? We got soaring Vietnamese stocks to buy! Greek bonds at 7% are looking mighty tasty.
Currently, I believe the JPY is in the second stage. People are starting to believe in the BoJ's resolve to do its massive thing, but they are also seeing how the end result of 2% CPI is apocalyptic (perhaps it could be realized in the long run, but any short-term realization would create chaos). Therefore they will gradually realize that the scenario was just a red herring.
The USDJPY will bounce around in a range as the U.S. Treasury/G8 will express displeasure at an overly weak JPY, while comments from "sources" will weaken the JPY when it is too strong. Risk events like a financial crisis in Argentina, if they happen, will create sharp upwards spikes in the JPY, but these are unlikely to be lasting.
Additional disclosure: Mostly just trading this in a range now, price is very choppy.