Yen Intervention, The 'Grand Bargain' and Pace: Faros Trading Special Report

 |  Includes: CYB, EPHE, EWY, FXY, UDN, UUP
by: Douglas Borthwick

From October 22-23, 2010, the G20 finance ministers met in South Korea to discuss the world's imbalances in an effort to globally coordinate and unwind imbalances that resulted from the collapse of Lehman Brothers and the correlated flight to quality into the U.S. dollar. Going into the meeting the market was very aware of the 'beggar thy neighbor' policy being exercised throughout Asia and to a lesser extent Latin America; as each country sought to keep its currency weak via daily intervention.

The G-20 Finance Minister Meeting culminated with what we described as a "Grand Bargain" between the United States and China. This bargain agreed China would gradually strengthen the Yuan while stimulating domestic demand, as agreed upon in China's 5-year plan. At the same time it would allow the U.S. to lower the value of the USD over time, thus stimulating the U.S. export business and helping enable President Obama's 5-year export initiative (described by the Obama Administration as their number one priority).

Coming out of that meeting many of the countries throughout Asia and South America knew that their currencies would strengthen against the dollar, but they became increasingly worried about the pace of that appreciation. While a stronger currency would help combat the inflation being imported into their economies, it would be very hard on their domestic exporters. For this reason the discussion at the G20 summit in November centered more around the actual pace of this move. Countries were assured the pace would be gradual and in line with the needs of China and the United States. China knew that an overnight revaluation of the Yuan would do no good to the Chinese economy, and the U.S. knew that its exporting market was not established enough for the full U.S. economy to benefit from an immediate devaluation of the USD.

Once member countries had agreed and were satisfied with the pace, the meeting broke up. The EUR/USD strength going into the November meeting was immediately met with statements from French President Sarkozy and German Chancellor Merkel regarding EUR/USD strength and peripheral weakness ... Essentially breaking the 'Grand Bargain' in the first week. On November 30th, 2010, the U.S. dispatched U.S. Treasury Undersecretary for International Affairs, Lael Brainard, to Madrid, Berlin and Paris to urge European Leaders to halt their finger pointing at peripheral states and support the EUR/USD. Both Merkel and Sarkozy did just that, talking about their support of the EUR/USD at their New Year addresses. We were not surprised that Brainard was sent over to Europe, after all, she is also the Treasury Undersecretary in charge of the Chinese Yuan discussions. You see, as we have proven many times, USD/CNY can not go lower unless the EUR/USD goes higher ... And back in November, the EUR/USD was going lower on the back of French and German malaise and finger-pointing. This created a problem for China and the U.S. because it meant that USD/CNY was facing headwinds to moving lower going into the state visit from Chinese President Hu. Long story short, Merkel and Sarkozy came out in support of the EUR/USD and USD/CNY dropped.

Inherent in this "Grand Bargain" was the notion that all nations would allow their currencies to strengthen gradually. This was working very well, up until the earthquake and tsunami in Japan caused a massive strengthening of the JPY relative to the USD, but more importantly against the KRW and the CNY. Japanese authorities are very correct in their statements that Life Insurers were not repatriating back to the JPY, causing JPY strength. It was not the life insurers, but rather the retail FX traders who were unwinding positions and being called on their margin. It is hard for many to believe this could be the case, given the small size of the US retail foreign exchange market, but the truth is sobering. The BIS Survey tells us that 20% of all trading in the FX Market is in the JPY. The BIS also tells us that 30% of all JPY trading is done by Japanese retail accounts. With the daily turnover in the FX Market estimated as $3.8 trillion USD, this would put daily retail FX trading volume for Japanese investors at about 228 bio USD. With margins averaging 20-1, the extreme move in USD/JPY over the period (-8% from March 10 to the lows) caused a good amount of margin call liquidation (estimated at around 60 Bio USD between 4:55pm and 6:00pm on Wednesday evening).

In the days prior to intervention we noticed an extreme pick-up of USD/Asia selling by the central banks of Korea, Indonesia, Taiwan and the Philippines. They sold the USD against their currencies in part to lower volatility, but more importantly so that it did not look like they were allowing their currencies to weaken against the JPY so as to either attract Japanese manufacturing companies to set up shop in their countries, or so as to sell more goods on a relative basis than Japan given the JPY's strength in the global market.

The levels of 7.00 in KRW/JPY and 12.00 in CNY/JPY were both breached on Wednesday evening. This breach caused us to advise our customers of our expectation for an imminent global coordinated intervention to weaken the JPY; for the sole reason that the "gradual pace" agreed to at the G20 was no more, and needed to be rectified. Those party to the "Grand Bargain" did so on Thursday evening and Friday throughout the day, with intervention being carried out on behalf of the BOJ by the central banks of the U.S., Europe, Canada and the UK. On Thursday evening following the massive intervention, we advised our customers to sell USD/JPY between 81.50 and 82.00. The high was 81.99. We made this advisement because the levels of KRW/JPY and CNY/JPY were back at their equilibrium levels; where equilibrium level is defined as 'back in range'.

The question in the market today is will intervention continue? We advise that it will only continue if KRW/JPY or CNY/JPY drop out of their trading ranges again. If USD/Asia, most notably USD/KRW and USD/CNY were to drop 5% over the next few months, we would expect USD/JPY to do the same. If they were to rise by that same amount, we expect USD/JPY to mirror the move. We argue that USD/JPY is just another boat in the same tide with USD/KRW, USD/CNY, USD/PHP and all the other dollar crosses throughout the Asian region. The Japanese authorities have said as much over the past few days as they have stated they are not looking to weaken the JPY, rather, as Japan's vice-financial minister stated they "want the yen to return to the level before quake, and don't want the yen to weaken too much." Intervention will only happen if the JPY strengthens out of its trading ranges against the KRW and the CNY. If it stays within the range and remains relatively competitive, then further intervention will not happen. Intervention will be deemed successful up until the JPY moves out of its range. With CNYJPY at 12.38 and KRW/JPY at 7.24, so far we note it has been very successful.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.