Yen Weekly Outlook: Week Of May 27-31

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Includes: FXY, UDN, UUP
by: Cliff Wachtel

The stereotype of the Japanese business model has been to develop and improve on foreign innovation rather than develop it at home. However, Abenomics, is a form of stimulus so radical that it's widely recognized as a huge experiment, if not outright gamble, with Japan's economic future at stake.

In sum, features three "arrows":

  1. Massive monetary easing and simultaneous debasement of the JPY to help exports and spur domestic consumption. Admittedly there are contradictory elements here. A cheaper yen helps exports and so brings more cash, but more expensive imports limit the net positive effect
  2. A big burst of government spending
  3. A promised growth oriented deregulation and trade liberalization

Against a background of Fed easing and calm in the EU, the mere hope for this kind of program got Japanese and related Asian markets rallying since last July, and its recent initial steps have fed that rally.

However, last week's surprise news that the Fed might curtail QE later this year presents a new challenge for the Japan's drive to pump up stocks and personal consumption via debasing the JPY:

The fed news obviously pressures stocks, as much of that QE liquidity has been flowing into Japanese stocks (about $3 bln just last week alone, after the prior week's record inflows). A cut in QE could reduce those inflows, hence the dramatic 7% drop Thursday.

Surprisingly, the news also sent the JPY higher. QE debases the USD, so one would think the USDJPY would have gone up. Why did the opposite happen? Two reasons:

Some buyers of Japanese stocks were buying the USDJPY (shorting the JPY) to hedge risk of further declines in the JPY. As Japanese stocks sold off, so did those USDJPY positions, hence the short term pop in the JPY.

The 10bp surge in ten year U.S. Treasury yields Wednesday and Thursday caused JGB yields to gap higher, which in turn triggered the sell-off in the Nikkei and thus the USD/JPY.

Worse than expected Chinese manufacturing PMI numbers exacerbated the risk aversion flows into the JPY from the USD and other currencies higher on the risk spectrum

At this stage, the consensus is that last week was just an inevitable overdue pullback given the rapid rise of the Nikkei. The longer term USDJPY trend remains intact for now, as long as the gap between Fed and BoJ policy continues to grow, with the Fed steady or tightening, and the BoJ continuing to ease monetary policy.

Still, as the week opens, last week's reversal continues, with the JPY rising versus the USD and the Nikkei again plunging, closing Monday down over 3%.

Going forward, the big questions are:

  1. How far ahead of reality has bullish sentiment gotten on Japanese stocks?
  2. Can Japan bond yields stay low and stock prices remain high if QE cutbacks in fact do come, or other negative surprises dampen investor optimism?
  3. How does Japan say it's going to buy stocks and bonds and avoid feeding an unsustainable rally in these that will crash as the government eventually backs away from its radical intervention?

If the markets decisively turn on Abe and the profit-taking move snowballs into a deeper pullback, it's unclear how much Japan can do.

  • It cannot easily make further dramatic government spending increases or postpone a planned sales-tax hike without undermining confidence in Japan's seriousness to reduce over 200% debt/GDP ratio, the highest in the developed world.
  • It's been known for years that Japan's aging population, with 25% already over age 65, cannot continue to keep buying low yielding Japan Government bonds to finance that debt. If Japan needs to turn to foreign markets where even the US 10 year notes yield double those of Japan, yields could spike hard. Debt service already accounts for 25% of Japan's budget. If yields even approached those of the US debt service would consume 50% of Japan's budget. Could Japan print enough Yen to cover that annual increase without causing an uncontrollable Yen selloff and economic death spiral or rising debt costs and falling Yen?
  • To keep bond yields down, monetary options include a BoJ version of the ECB's LTRO program, essentially backstopping short term bonds, and also increasing ETF and J-REIT purchases. On the fiscal side, Japan could delay the consumption tax hike due in April 2014 or other measures to increase consumer spending.

That risk raises the stakes for Abe's "third arrow", new legislation and regulations to spur growth. Details are expected in June, and are believed to include tax changes to encourage corporate investment, steps to encourage more women in the workforce and liberalization of the power and healthcare sectors.

This raises a fourth question, how much extra growth can you get from legislative tinkering? Real long term growth comes from increases in either population or productivity. Japan' working age population is falling. Barring some unforeseen technological breakthrough, industrial economies can only increase productivity slowly at best.

There's fifth big question. Can Japan sustain export growth from continued Yen debasement? A key element to Japan's recovery strategy is a cheaper Yen that drives exports. That assumes that Japan's competitors and customers (who are often the same) allow Japan to cheapen its currency and thus export its deflation. At some point other nations will respond in kind and debase their currencies.

Indeed, regardless of what Japan does, as long as the global economy keeps slowing, central banks will tend to cut rates in order to help exports and encourage growth. Just last week, no less than 14 central banks cut rates. See our post on lessons for coming week here for details, in the section "Currency Wars: Smaller Central Banks Strike Back." Except for the central banks of Korea and the ECB, none of the other nations are direct competitors of Japan in most export sectors.

In sum, the JPY downtrend remains intact for the near term at least, and certainly for the very long term given the dire outlook for Japan. John Mauldin just came out with a good piece summarizing Japan's bleak outlook. See here for details. You can play that via a direct long position in the USDJPY or other Yen shorts, or by shorting the FXY or using other ETF or ETN instruments. Beware of using leveraged short Yen ETFs for more than a few days. For technical reasons, these fail to track the Yen's downtrend well beyond a very brief period.

Support for the USDJPY should hold around 100, and only a break below the 99.6 zone would suggest a significant further pullback.

Key Events This Week

In addition to those covered in our weekly global market preview, top Yen related events include:

Monday" Monetary Policy Meeting Minutes

Wednesday: Japan retail sales y/y, BoJ Gov Kuroda Speaks

Saturday (June 1): China Official Manufacturing PMI

Reminder

Most major central banks want to debase their currency, and any assets linked to it. If most of your assets are denominated in the USD, JPY, EUR, AUD, or other at risk currency, you need to hedge that risk and diversify assets by currency as well as by asset and sector type.

Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.