Yen For Dollar?

| About: Alibaba Group (BABA)


Discussion of the potential impacts on equity, bond, commodity, capital and asset markets regarding the following.

Currency risks; transactional; portfolio and structural.

Yen short covering; yen/USD carry trade; dollar liquidity issues.

Effect on Japanese and Chinese exporters; carry demographics.

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Godzilla, 1954 - The world is beset by the appearance of monstrous creatures, but one of them may be the only one who can save humanity. Producer Tomoyuki Tanaka stated that, "The theme of the film, from the beginning, was the terror of the bomb [atomic]. Mankind had created the bomb, and now nature was going to take revenge on mankind."

Above note JPY versus USD's steady ascent with yesterday's huge +3% post BOJ candle. Last night's +3 JPY/USD move, and a 14% move since June 8, 2015, have had an impact on Japan's banks, exporters and economy.

The Yen, which is now up 10% since February... that's very bad for Japan's export-based economy as the same $20,000 Toyota that put 240,000 Yen on TMs books in Feb is now putting 216,000 Yen in their pockets in April. They already made the car and shipped it 3 months ago and they paid their workers and parts suppliers in weaker Yen at the time so this change in currency essentially wipes out all of their profit on the car - that's why this matters so much - especially to a net exporter (and that goes for China too).

- Philip Davis

The example above speaks to currency risks which can affect the books (cash flow) in real terms, vis when currency changes are adjusted for differences in inflation. Long term, most currency fluctuations tend to be offset in real terms by price changes. In addition, hedging can be affected through futures, swaps, or options.

There are three kinds of currency risk. Transaction risk arises through delivery commitment versus actual cash flow timing vis delivery and settlement or payment terms. These are short-term, one-off situations which can be dealt with straightforward through synthetic hedging.

Portfolio risk arises when one has business transacted in foreign currencies, vis a retailer of products in Japan and the US. If the yen goes up 15%, my sales get 15% less cash flow on the yen side. Ceteris paribus, no hedging is required when flows act in harmony vis the -15% yen flow is offset by a +15% dollar flow - it all comes out in the wash. Again, price changes can come into play.

Structural risk arises when the flows react differently, causing a mismatch on the books. These kinds of swings and flow mismatches are difficult to hedge against, vis a vehicle manufacturer in Japan that sells in the US. Operating costs are in yen, sales revenue are in USD - say, they have a 15% US operations margin in dollars.

A 15% drop in USD/JPY drops margin to 2% (operating expense in yen rises +15%), resulting in a drop of 85% in operational cash flow, amplified by a -15% dollar revenue drop = 95% less cash flow.

In order to reduce the mismatch in flows, most auto manufacturers naturally hedge by opening manufacturing plants in their prime markets, vis Toyota manufactures in the US, lowering their structural exposure to USD. Again, price changes can come into play.

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Above note, Godzilla, 1998. Three things have made the yen jump against the dollar.

1. Short covering - Everybody, including the big banks, was betting on BOJ furtherance of ETF and bond buying, which would weaken the yen. When the assumed handout turned up empty, all those commercial net short positions got torched, pushing the yen even higher on short covering.

Above note, commercial net short JPY at a four-year high.

2. Carry trade margin call - When the yen rises, carry traders who previously borrowed in cheaper yen to obtain "dollars" must cover their rising yen positions, forcing liquidation of liquid assets to make margin calls. Hence, the Nikkei and other major indices sell off.

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Above note, the large Nikkei 225 red candle and the relationship to the JPY/USD pair.

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Above note, Godzilla, 2014.

3. Declining global "dollar" liquidity - The yen is still the carry trade of preference to swap into dollars. Borrow cheap yen, obtain dollars through forward swaps paying a negative spread. When yen are bought to swap out dollars, this ultimately takes yen off the market, lowering the float - less yen, higher value. At the same time, dollars being swapped are released or flooded into the market, so float increases - thus, a lower dollar.

Above note, the Fukushima nuclear plant disaster; last weekend's 7.0 earthquakes and the BOJ's real problem, yen being used in carry trades to obtain "dollars"; and Raymond Burr.

Did you know? Burr's character, Steve Martin, was never in the 1954 original. The studio added new footage featuring Burr interacting with Japanese-American actors and lookalikes to make it seem like he was part of the original Japanese production. Most of the political, social, and anti-nuclear themes and overtones were removed completely from the 1956 Americanized re-release titled Godzilla, King of The Monsters.

Carry Demographics

This may seem counter-intuitive: borrow and swap yen that will increase (forcing margin call) for "dollars" that will decline - that's called getting double-ended in a bad way. Why would anyone do that? Because those who do not have those "dollars" MUST buy those "dollars" to transact.

It is not the FX pairing JPY/USD that indicates the real "dollar" demand, value or cost of those "dollars". That "dollar" value is reflected in the spread (the cost) for the forward swap contract being negative. This tells you how sought after those "dollars" are.

In 2015 Japan shipped $625B overseas, down 25% from 2011 and down 10% in 2015. The US accounts for 23% of all Japanese exports. Japan imports 24% of its goods from China, amounting to $160B in 2015. Of Japan's global exports, automobiles are 22%, machines are 19% and electronics are 15%.

How will the continued currency risk pressure on Japan affect Japanese exporters Toyota (NYSE:TM), Honda Motor (NYSE:HMC), the country's banking system and Chinese exporters such as Alibaba (NYSE:BABA)? Will the continued failure of Abe Kuroda monetary policies ultimately destroy what is left of the Japanese middle class?

We repeat, a 15% drop (which we have seen since last June) in USD/JPY can result in 95% less cash flow for Japanese exporters that sell to the US and China (the RMB is tethered to the dollar). Much like Godzilla on a rampage through Tokyo, the yen carry has got to go, but apparently neither man, machine, nor central bank can stop it. What can we say? Oh-oh, there goes Tokyo... history shows again and again, How nature points up the folly of men.

All the above and other consequences and considerations were previously Nattered about at length in the articles "Dollar Chaos? Or Ran?," "A Yen For Yuan?," "Run On Yuan?" and "A Dollar Melt Up?"

Would like to thank you folks fer kindly droppin' in. You're all invited back again to this locality. To have a heapin' helpin' of Nattering hospitality. Naybob that is. Set a spell, take your shoes off. Y'all come back now, y'hear!

This is our 101st in a series of thematically related missives which will attempt to identify the macroeconomic forces with potential to adversely effect capital, commodity, equity, bond and asset markets.

I wish to dedicate this missive to one of my mentors, Salmo Trutta, who is a prolific commenter on SA. Without Salmo's tutelage, and insistence on not masticating and spoon-feeding the baby ducks, as in learning the hard way by doing the leg work and earning it, this missive would not have been possible. To you "Proximo"... "win the crowd and win your freedom" - Spaniard.


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Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of an investment vehicle. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from the principal or a financial advisor. Prospective investors should read the prospectus carefully before investing.

Market Plays

As for how all of the above ties into the potential and partial list of market plays below... the market as a whole could be influenced, and this could tie into any list of investments or assets. Those listed below happen to influence the indices more than most.

There are many macroeconomic cross sector and market asset correlations involved that affect your investments. Economic conditions, the eurodollar, global dollar debt and monetary policy all influence the valuation of the above and market plays below, via King Dollar's value, credit spreads, swap spread pricing, market making, liquidity, monetary supply and velocity, just to name a few. For a complete missive series listing covering those subject and more, click here.

The potential global economic developments discussed in this missive could affect numerous capital and asset markets, sectors, indexes, commodities, forex, bonds, mutual funds, ETFs and stocks.

A List of 17 Potential Market Plays (Long or Short?): Apple Computer (NASDAQ:AAPL); Google (NASDAQ:GOOG); Facebook (NASDAQ:FB); Microsoft (NASDAQ:MSFT); Citigroup (NYSE:C); General Electric (NYSE:GE); Cisco (NASDAQ:CSCO); Bank of America (NYSE:BAC); Amazon (NASDAQ:AMZN); Tesla (NASDAQ:TSLA); SP 500 Trust ETF (NYSEARCA:SPY); Ford (NYSE:); Starbucks (NASDAQ:SBUX); Intel (NASDAQ:INTC); ATT (NYSE:T); IBM (NYSE:IBM); Exxon Mobil (NYSE:XOM).

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.