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The past few weeks have been rife with horrifying headlines. The limelight has shifted from Egypt to Libya, and now of course to Japan. The geopolitical risk spectrum is huge, and investors are running scared as a result. To highlight the hysteria, let's dig into the numbers.

Currencies: Australian dollar, Swiss franc and the Japanese yen:

Let's start with two currencies that have nothing to do geographically with the panic-stricken areas, the Australian dollar vs. the Swiss franc. The following chart shows the Australian dollar vs. the Swiss franc over the past two years.

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Australian Dollar (<a href='' title='PIMCO Australia Bond Index ETF'>AUD</a>) vs. Swiss Franc (CHF) Chart

As can be seen, the Australian dollar has gotten nothing short of annihilated against the Swiss franc over the past few days, falling by an incredible 5.6% over the last three days. For those of you not familiar with currencies, this is an absolutely gargantuan move.

The Australian dollar is typically thought of as a "risk" currency while the Swiss franc is considered a "safe haven" currency. One can see the rough effects of this by witnessing the somewhat similar trajectory of the Australian dollar as the S&P 500.

In our current crisis, the relationship between these two currencies is very much a "risk on, risk off" situation in which currency investors are panic-buying the Swiss franc and fleeing anything thought of as risky every time someone from the U.S. or EU nuclear regulatory body opens their mouth. This flight from perceived risk is telling proof of the recent irrationality of currency investors.

When buying the Australian dollar against the Swiss franc, investors get paid about 2.67% per year (net of broker fees) because the Australian central bank rate is so much higher than the Swiss rate. Conversely, if selling the Australian dollar against the Swiss franc, investors would have to pay 6% annually to the broker to effect the trade. However, because forex is so leveraged, the effects of this interest rate differential are highly magnified. For example, if selling 100,000 AUD against the CHF, an investor would only have to put up about $2,500 to put on the trade (at 40:1 leverage, a typical ratio for forex), but would have to pay $6,000 annually just to keep the trade on. If buying the AUD against the CHF, the investor would still only have to put up $2,500 to put the trade on, but would actually collect $2,670 per year. As is obvious from the calculations, a rational, non-risk averse investor would be much more amenable to owning the AUD than the CHF, and the steady rise in the exchange rate over the past two years reflects this.

As is typical of market panics, investors are selling first and asking questions later. If there is any good news out of Japan whatsover (and admittedly this is a large if), the Australian dollar should stabilize, and even if it meanders around its current exchange rate, investors are being paid to carry the currency and wait while the market calms down.

To view the irrationality of the market even more extremely, let's consider the U.S. dollar vs. the Japanese yen. The following chart shows the last four days.

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US Dollar (<a href='' title='ProShares Ultra Semiconductors ETF'>USD</a>) vs. Japanese Yen (JPY) Price Chart

The reasons that most market prognosticators have given for the yen rallying after the earthquake is that the yen always rallies in panics, and that the Japanese will need to repatriate their assets to Japan to pay for the damage. However, upon further review of the yen's recent trading, repatriation cannot be the reason for yen strength.

On Wednesday, the head of the U.S. Nuclear Regulatory Commission, Gregory Jaczko, spoke about the nuclear situation in Japan in dire terms. As a result, the yen gained 4.33% against the dollar almost instantly before giving up much of the gains quickly. A 4.33% move for a currency is a huge one, and for it to happen in a matter of seconds indicates massive panic-buying. After all, if I told you that a country was currently experiencing a nuclear disaster, and that the implications of the event were worsening, would that make you want to own that country's currency more or less?

Buyers of the yen are pure speculators who are anticipating fear. There is no other explanation for the market's reaction to commentary by the NRC chief. If the situation were to truly spiral out of control in epic proportions, and Tokyo were to become uninhabitable (not saying this is even a possibility, but using it as a hyperbole), would anyone want to own yen when the country itself is collapsing?

Also, the Bank of Japan has repeatedly indicated its willingness to devalue the yen. This is because Japan's economy is extremely dependent on exports, so if the yen becomes too strong, Japanese exports become unattractive. The BOJ intervened directly in the currency markets back in September when the yen reached 82/dollar. Our feeling is that the BOJ will not stand idly by and watch its currency and economy go up in flames, but will vastly increase current quantitative easing programs and again intervene directly in currency markets to devalue the yen. As they do so, they will step up purchases of Japanese stock ETFs, REITs and Japanese government bonds, as well as sell the yen directly into the currency markets (which they have already done in the recent past). This is essentially a version of U.S. quantitative easing on crack. If the situation truly becomes dire, the G7 could even act in concert to intervene and devalue the yen (such an event occurred in 2000 when the G7 acted to support the euro).

In another sign that repatriation is not the cause of JPY strength, we can look at the price of U.S. treasury bonds. Since Japan is the number two largest holder of U.S. treasuries in the world at $885 billion (behind China with $1.15 trillion), if the Japanese were in fact repatriating assets, it would stand to reason that we would see heavy selling in treasuries, or at least muted gains given the expected domestic U.S. fear-buying of treasuries. A chart of the USD.JPY and U.S. treasury bond is posted below.

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US Dollar vs. Japanese Yen and 30 Yr US Treasury Bond Chart

As can be seen, the dollar has dropped big against the yen since the earthquake while the U.S. treasury has simultaneously rallied. To be clear, this is a typical "fear" response of the market. Risk-off usually means yen and treasury strength. However, in this case, if the Japanese were in fact looking to repatriate assets, a very likely target would be their massive holdings of U.S. treasuries, which they could sell and convert to yen if they needed cash. The chart above indicates that, at least so far, this is not the case. The U.S. treasury has experienced almost the exact same strength as the yen has, indicating that the buyers of both are one and the same ... panicked investors running to their usual perceived safe havens.

The market is ignoring that the problem itself is in Japan. If Japan truly does suffer an even greater blow to its economy from the nuclear crisis worsening, the ability to pay back debt (the largest in the industrialized world), will be even further imperiled. Additionally, since the economy is heavily dependent on exports, the higher the yen goes, the less Japanese companies make and the less the Japanese government receives in tax revenues, thereby making a Japanese government default more likely. Therefore, the higher the yen goes only means it will fall all that much harder eventually.

The market's knee-jerk reaction so far has been to buy the yen first and ask questions later, but we believe that, in the long run, the yen must devalue for a myriad of reasons, including that the Japanese themselves would welcome a devaluation with open arms.

Trade Recommendation

Before recommending a trade, we would like to make clear that currency trading is extremely risky due to the volatile nature of geopolitics and the high degree of leverage involved. That being said, currencies can offer some of the best risk/reward characteristics for trades, and we believe the current situation lends itself.

We would recommend purchasing the Australian dollar against both the Swiss franc and the Japanese yen, as well as purchasing the U.S. dollar against the Japanese yen. This trade could be highly volatile in the near term due to the Japanese nuclear situation, but as things calm down over the coming weeks and months, we believe this will be a profitable trade.

In times of fear, speculation and panic reign supreme, but with them come enormous opportunity for the calm, long-term minded investor. Stay tuned for part 2 of this series discussing the Japanese situation's effect on U.S. stocks.

Source: Japanese Crisis Analysis Part 1: Currencies and the Return of Panic

Additional disclosure: long AUD against USD, long AUD against CHF, long AUD against JPY, long USD against JPY.

>> Continue to Part II