I'm expecting the yen to depreciate against a basket of currencies despite the recent market correction. A weakening yen is also indicative of a strengthening Japanese equity market. The two go hand in hand, because inflationary policy will increase the value of securities.
However, I don't want to explain every aspect of the Japanese economy in this article. The topic is too dense, and convoluted to go into very much depth on Seeking Alpha. What I'm really trying to get at is a unique investment idea that operates on a global scale.
Japanese yen should trend lower
At the present moment I think that it's pretty improbable that the Federal Reserve will slow down the pace of its taper despite the semi-dovish comments by Janet Yellen pertaining to the weather. While, weather could delay the Federal Reserve from making another $10 billion reduction to quantitative easing, the odds of that happening are slim as weather is a seasonal pattern that's very temporary. The Federal Reserve can't make long-term policy decisions on seasonal trends.
The sheer scale of the Federal Reserve's balance sheet has gotten a little too cumbersome and any further intervention on the part of the Federal Reserve could make the United States economy a little too dependent on monetary stimulus.
Source: Federal Reserve
Note: The Federal Reserve has $1.6 trillion in MBS.
Note: All the commercial banks in the United States have $1.35 trillion in MBS. The Federal Reserve alone owns more mortgage securities than all of the commercial banks in the United States combined.
Because the risks to the financial system were unprecedented at the time (2007-2009), the Federal Reserve has no choice but to conduct open market operations. Now that the United States economy has been able to post positive economic data, and is on track to meet the Fed's inflationary, growth, and unemployment targets, the Fed has no choice but to taper.
More specifically, the Federal Reserve's balance sheet is too large and it needs to be reduced in size. Now the Federal Reserve has no plans of selling any of the assets on its balance sheet in order to drain liquidity. But if in the event the United States economy were to be hit by another economic recession, the Federal Reserve needs to free up enough room on its balance sheet to initiate a combination of interest rate policy and asset purchases. This implies that the Federal Reserve will be waiting for many of the assets it already owns to mature, which would reduce the Fed's direct involvement in the economy, and also prepare it to absorb some of the damage from the next economic meltdown (whatever form it takes).
So in summary, I'm bullish on the dollar and bearish on the Japanese yen. The Federal Reserve has no choice, but to decrease the size of its balance sheet, whereas Japan has no choice but to increase the scale of its quantitative easing program in order to boost exports and induce a wealth effect. The decline of the Japanese yen is virtually certain under these conditions, because the Japanese economy needs to overcome declining population growth with a massive increase in overall labor productivity. Labor productivity alone has proven insufficient as the Japanese economy has shown no signs of improvement over the past couple decades. So the only other option is to increase the amount of broad money.
Facts and figures
While it's hard to beat the inflation figures coming out of China, the Japanese yen's asset purchase program and low interest rate policy is expected to persist for much longer than it will in the United States and the European Union.
Bank of Japan Assets data by YCharts
Currently the Bank of Japan is accumulating assets at a much faster pace than the Federal Reserve. With the Federal Reserve initiating a taper, eventually Japan's asset figures will surpass the United States'. This isn't a Ponzi scheme however, because all of the interest that's earned on the assets will be returned to the treasury, which is precisely why sovereign debt is usually considered risk free. However it doesn't always generate returns above the inflation rate, which could be a bit of a problem for those who are depending on interest income for retirement. But that's a completely separate topic that could be elaborated even further in a different article.
Source: European Central Bank
Note: Eurosystem assets in millions of Euros.
The collective central banks that make up the eurozone have reduced the size of their balance sheets. Inflationary risk is taken much more seriously in Europe than in the United States or Japan. Whether or not this is the right policy decision is up for debate, but the impact it will have on the currency exchange is fairly predictable at the present moment.
I expect the dollar-yen to continue to trend higher. I wouldn't take resistance levels at 103.2, 103.8, and 105 very seriously. By the end of the year I expect the dollar-yen to trade at multi-year highs. I expect resistance levels to be extremely temporary throughout the course of the year.
The same trend is emerging on the euro-yen currency pair. The euro has found a base at around 136, and continues to trend higher. The macroeconomics largely favors the euro's appreciation against the yen, which implies that the recent pullback is another buying opportunity for the bulls.
This paints a pretty dim picture for the Japanese yen against a basket of currencies. Already, two of the most major currency pairs it trades against (euro/dollar) are moving against it. This trend isn't going to change anytime soon as Japan is much more committed to monetary and fiscal stimulus than the United States and Europe.
Opening positions on the Japanese yen
I have a position on the Japanese yen by shorting it through an ETF. It's an indirect play with the CurrencyShares Japanese (FXY), but I hope to earn a pretty sizeable return by putting on a bit of leverage in this trade. Granted, not everyone has to do it my way as there are numerous ways to trade the yen (futures, FOREX). However this currency trust pretty much owns the yen, and the value of the currency trust trades based on the fluctuations of the USD/JPY and EUR/JPY currency pair.
The Japanese yen is the third most traded currency pair in the world and accounts for approximately 23% of global foreign exchange transactions, with the vast majority of the transactions based on the USD/JPY currency pair, which alone represents 18% of global foreign exchange transactions, according to the Bank for International Settlements. Therefore, the value of the Japanese yen ETF is primarily based on the USD/JPY and the EUR/JPY currency pairs.
In January, the Oriental Trader on Seeking Alpha mentioned:
The tune sung before this week was something like this: Fed is going to exit printing, Japan isn't, so USDJPY should go up and up. However, this logic is fallacious. When there are few factors impacting the markets, we see US-Japanese yield differentials having high correlations with the USDJPY. But tapering itself became a catalyst for market uncertainties, especially in the emerging markets, which both increased risk aversion and decreased the US-Japanese yield differential.
However, I believe that Oriental Trader's logic falls short, because the thought process was a little too short term. The up-trend of the dollar and euro against the Japanese yen will most likely persist. The volatility index has peaked for the most part, which implies that uncertainty and the risk-off trade is pretty much dead at the present moment. This implies that the "differential" will actually increase, and with some bad economic data being reported, Japan is a long way away from tapering.
While I disagree with much of the banter that was presented by "Tyler Durden," the economic chart is pretty useful to look at. Fact is, despite a member of the BOJ being a little hesitant to pursue further QE, it's unlikely that there will be much political support for an early exit, especially when considering Japan's machine orders fell by as much as they did in the past month. However, machine orders as you can see, are very volatile and it's not always a forward indication of a recession. Personally, I just think Zerohedge is jumping on the anti-yen bandwagon because it sounds contrarian enough to be attention grabbing.
According to the Bank of Japan:
Switching from a "goal" to a "target" reflects an increasing awareness regarding the importance of flexibility in the conduct of monetary policy in Japan. The effects of monetary policy permeating economic activity and thereafter prices require a considerable and variable time lag. The conduct of monetary policy has to be flexible by examining various risk factors, including those related to financial imbalances, in addition to the assessment of current developments and outlook for economic activity and prices, from the perspective of achieving sustainable growth with price stability.
In laymen's terms, the Bank of Japan is stating that it's going to adjust its strategy based on economic data, and has every intention of sticking with its target of 2% CPI growth.
According to Market News:
Bank of Japan board member Takahide Kiuchi, who is against a rigid two-year timeframe for achieving 2% inflation, said side-effects of an additional easing would be bigger than its positive effects if the economy were deviating only slightly downward from the BOJ's recovery scenario, the Nikkei reported.
Source: Bank of Japan
However according to the most recent meeting by the board of the bank of Japan, forecasts of 2% CPI inflation reaches a consensus by 2015, implying that an early exit encouraged by the board member Takahide Kiuchi will largely be ignored by the Bank of Japan governor Haruhiko Kuroda. This is because a premature taper could reduce the chances of the Japanese economy reaching 2% CPI growth.
According to Reuters:
Bank of Japan Governor Haruhiko Kuroda said on Wednesday he will not hesitate to adjust the central bank's quantitative easing if upside or downside risks to the economy and prices appear.
Kuroda, speaking in the lower house budget committee, also said the amount of outstanding government debt held on the central bank's balance sheet is more important than the flow or pace at which it acquires debt.
So if any "bad" economic data comes from Japan, Mr. Kuroda won't mind tacking on a couple months or even a couple years to its quantitative easing program. So I'm pretty confident that the dollar-yen will continue its uptrend for the foreseeable future.
Based on monetary policy, it's highly likely that the Japanese yen will continue to depreciate against a basket of currencies. The Federal Reserve's taper is slow, and if anything the caution demonstrated by the Fed should signal investors how cautious Japan will be when it eventually decides to reduce the size of its balance sheet.
For now, the eurozone continues to wind down its open market operations with the amount of assets continuing to decline. With the dollar and the euro representing the vast majority of the yen's daily trading volume; it's safe to assume that the fundamentals of the yen trade are soundly intact. Therefore, I believe that the yen will continue its downtrend.