Japanese Prime Minister Shinzo Abe's Abenomics has largely been driven by aggressive monetary easing initiated by the Bank of Japan (BOJ). The BOJ has aggressively expanded its balance sheet in hopes of increasing inflation, weakening the Yen (FXY, JYN, YCL, YCS), and driving down real interest rates. While the BOJ has succeeded on all three fronts, the efficacy of increasing inflation and weakening the yen to the benefit of the broader Japanese economy has been unresolved.
The Inflation-Currency Link
Inflation and a weaker currency are of course interconnected. A weaker currency pushes labor costs down and makes exporting goods easier. However, it also imports inflation due to the higher import prices, thus decreasing purchasing power. Often times as imports grow more expensive, consumers can substitute cheaper domestic alternatives and thus improve the country's balance of trade. Conversely a strong currency pushes labor costs up, makes exporting goods more difficult, but also increases the consumer's purchasing power. Export-oriented countries such as Japan have typically favored a weak currency as they have historically subscribed to a mercantilist mindset.
With regards to inflation, the aggressive monetary policy by the BOJ has accelerated inflation somewhat in Japan. Furthermore, there are some signs that the increase in consumer goods may make its way to wage inflation as workers negotiate a higher wage due to a higher cost of living. However, without commensurate wage inflation, it is doubtful that an increase in inflation will be welcomed by the Japanese consumer. Even now, over 70% of Japanese polled have not been feeling the benefits of Abenomics, while Japanese exporters have been ecstatic about the weak Japanese Yen.
As noted above, a weaker currency would be expected to help Japan's balance of trade. Unfortunately Japan's most important import is energy. Japan has limited domestic energy resources and domestically only produces roughly 15% of its total energy needs. This reliance on imported energy has been amplified by the shuttering of Japan's 50 nuclear reactors due to the nuclear meltdown at Tokyo Electric Power Co's Fukushima facility in 2011. Nuclear energy accounted for 30% of Japan's electricity and was Japan's greatest source of domestically produced energy. The impact of the falling Yen and greater need for imported energy sources have been apparent in the recent trade deficit reported in Japan as crude oil imports rose 28.1% and liquefied natural gas rose 21.4% from a year earlier. While Japan has always had to import energy, the shuttering of nuclear reactors have made energy imports even more inelastic with no viable substitutes to be produced domestically.
With energy imports limiting the efficacy of the BOJ's expansionary policies, the Japanese government has quietly been making preparations to restart Japan's nuclear reactors such as removing anti-nuclear members from the energy policy advisory board. Still, Abe has to convince the Japanese public as they have been against the resumption of nuclear energy in Japan with 60% polled opposing Abe's plans to use nuclear energy to spur growth.
Impact on the Yen
I have been negative on the Japanese Yen for a number of years, even prior to the start of Abenomics. My analysis of the current energy situation in Japan does not change that long-term outlook. My view of a depreciating Yen was always tied to a return of the carry trade, a dwindling trade surplus, and easing by the BOJ. However I do see two possible paths for the Yen in the short term: 1) the restarting of nuclear reactors; 2) continued shuttering of nuclear reactors.
Resumption of Nuclear Energy - In the case of restarting the nuclear energy program, I believe that the Abe and the BOJ will continue with aggressive monetary easing. The domestic production of nuclear energy will soften imported inflation via energy imports from a weaker Yen. Production in Japan will also be cheaper due to lower energy costs allowing companies to pass gains to Japanese workers. The Yen in this case should continue to be an ideal funding currency.
Rejection of Nuclear Energy - In the case that Abe is unable to restart the nuclear energy program in Japan, I believe that Japanese consumers may start to rethink about the efficacy of an ultra-easy monetary policy and resent exporters benefiting at the cost of rising consumer inflation. In this case I believe the BOJ may ease its aggressive monetary policy. While I do not believe the Yen will drastically strengthen for long even if monetary easing is tapered off, I do see the short Yen trade as a crowded trade that many traders will look to exit quickly. In this case, I believe that using the Yen as a funding currency will become extremely volatile.
While I remain short the Yen, I continuously look for scenarios in which my trade can go awry. I believe aside from a global pullback in risk assets, the tapering of aggressive monetary easing by the BOJ due to inflation from imported energy costs remains the greatest risk to shorting the Yen.
Additional disclosure: I am net short the Japanese Yen and have net short Japanese Yen positions for my clients.