Finally, after what seems to have been an eternity, the yen is breaking down and behaving in the way it should - at least according to my fundamental assessment.
My fundamental view on the Japanese yen relates the Japanese government bond market. At time of writing, the Japanese national government debt stands about 9.25 trillion yen (US$11.35 trillion). This represents approximately 220% of the nation's gross domestic product (GDP). However, the most bizarre thing is how Japan has been able to become one (if not the) most heavily indebted nations in the world but at the same time, have the lowest interest rates. The 10-year Japanese Government Bond (JGB) currently yields just over 1.3%.
There are essentially three reasons as to why Japanese interest rates have remained incredibly low:
- The high savings rate of Japanese nationals;
- Savings having been channeled into JGBs, resulting in over 90% of JGBs being held by Japanese citizens;
- A deflationary condition in the Japanese economy. Prices of goods and services have fallen for over 10 years.
But the winds of change are clearly blowing against the Japanese. For the last 10 years, Japan's savings rate has fallen linearly from over 10% in late in 1999 to approximately 1.95% today. This has been due to changing demographics.
Japan's population is now aging rapidly and the older the population becomes the less inclined they are to save. Today, approximately 25% of the population is over the age of 65. I am not expecting this trend to reverse anytime soon. This will ultimately result in a negative savings rate in the near future as a growing number of pensioners draw down savings during retirement.
Now as the Japanese start "dissaving" they will need to shift to offshore credit markets in order to merely roll maturing debt. However, the supply of new JGBs is likely to materially expand, mainly as a result of the government embarking on projects to repair damaged/destroyed infrastructure.
The more JGBs that are sold internationally, the more return investors will require to compensate for higher risks, i.e. foreign investors won't be so accommodating/loyal as Japanese nationals were. This is likely to be exacerbated if a condition of inflation rather than deflation takes hold in Japan. I am absolutely sure that inflation will occur as a result of both the earthquake and tsunami and also due to the "liquidity pump" of both the BOJ and Fed.
Perhaps the final nail in the coffin for the Japanese will be the impact of higher interest rates on already bloated government budgets. Japan has benefited from radically low interest rates over a number of years. The problem is that they are now essentially addicted to low interest rates. The average government interest rate is approximately 1% and interest payments alone already consume over 25% of all government tax receipts.
Consequently, if interest rates were simply to rise by two hundred basis points, it would materially impact Japan's ability to service its debt. Interest payments could easily consume over 75% of all government revenue unless tax revenues substantially increase, and I don't see that happening in the remotest!
How overvalued is the JPY? This question is best addressed by looking at how it is trading relative to emerging market currencies. I see absolutely no reason why yen crosses should not have followed the behavior of markets which they were highly correlated with up until mid 2008, namely: emerging equities (EEM), junk grade corporate bonds (HYG), US small cap equities (IWM) and commodities (GCC).
Of course, any avid market observer would know that these markets are now trading well above levels they were trading at in mid 2008. Yet emerging market currencies against the JPY are still trading at the same levels they were in late October 2008.
If my proprietary emerging market currency JPY index (below) was to get back to the level it was trading at in July 2008 this would suggest that the JPY is about 30% overvalued against a basket of currencies. If inflation takes hold in Japan and yields on JGBs rise then this figure could easily double.
Proprietary Emerging Market Currency JPY Index (15 emerging market currencies against the yen equally weighted).
Perhaps the massive "liquidity injections" by the BOJ some two weeks ago ultimately proved to be the tipping point of the JPY. It is not too late to get long the yen crosses. The hardest thing to do over the coming months will be to stay long the yen crosses and resist the temptation to take profits.