Short Yen: Great Strategy, Excellent Diversifier

Includes: FXY, YCS
by: Macro and Cheese

The Japanese yen is infamously expensive. According to the OECD, the yen is 24% overvalued in terms of purchasing power. The Economist Intelligence Unit identifies Tokyo as the world's second most expensive city, behind Zurich. But fortunes have been lost shorting the yen, which has not been above 100 since the fall of 2008, and has rarely been above 85 over the past year and a half. However, the economic landscape is shifting, and the yen should continue to weaken. Not only that, but a short yen position offers diversification in a world where markets increasingly move together.

Back in February here at Seeking Alpha I argued for a weaker yen, and the factors I cited remain in place. Here is a brief update:

(click to enlarge all charts)Yen, Interest Rate DifferentialClick to enlarge

In the above chart, the yen is shown in blue, and the US-Japan 5-year bond yield spread is indicated in red. The relationship is quite pronounced: The yen strengthens as the interest rate differential narrows towards parity. As we see, now that interest rates have bottomed in both countries, the yen seems to have bottomed as well.

Japan TradeClick to enlarge

The trade balance shows fundamental support for a weaker yen, moving the currency away from its equilibrium of a static interest rate differential. As we see, following a brief spike up following the March 2011 earthquake, Japan's trade balance has turned negative, meaning the country is importing more than it is exporting. The result disadvantages the yen, as the Japanese need to buy foreign currencies to balance out trade flows.

LNG world pricesClick to enlarge

One of the main reasons for this imbalance is Japan's near total reliance on energy imports. Being an island, Japan needs to transport its natural gas and crude oil by ship, and with all but one of Japan's 54 nuclear reactors shuttered out of caution following the earthquake, Japan's need for liquefied natural gas has soared. This has led to huge nat gas price discrepancies around the globe, as the map above indicates. With demand set to remain high until nuclear capabilities return, the need for more dollars to buy nat gas at a premium will persist.

The same can be said for crude oil, which has risen to over $100 per barrel from below $40 at the height of the economic slump in 2009. The dollar volume of Japan's crude oil imports has risen accordingly. Iran's crude supply reduction has put upward pressure on brent, at a time when Japanese demand for crude oil has risen 11% over the past twelve months.

Furthermore, with Japanese prices averaging a negative 0.2% annually over the past ten years, Japan has declared war on deflation, and has set a target of raising Japan's CPI to +1% as soon as practicable. As a part of this battle, Japan has recently increased its QE program, taking planned bond purchases to JPY 30 trillion ($368 billion) from JPY 20 trillion. Relative to Japan's economy, this QE program is larger than the Fed's QE2, a measure that materially weakened the dollar following Bernanke's kick-off speech in August of 2010. Quantitative easing is a relative game, and since Japan's central bank is the most recent QE administrator, this should put downward pressure on the yen.

As a part of the battle against deflation, Japan has been a regular seller of yen to buy dollars and euro. Not only does the government want to sell yen to encourage inflation, but also Japanese corporations are strong supporters of a weaker currency. Major exporters like Japan's auto makers and blue chips like Sony are struggling with the yen at 82, and a weaker yen would go a long way towards improving their competitiveness. Japanese lawmakers have been lobbying hard to populate the Bank of Japan with "doves" who would also favor a weak currency, and the political winds are at their back.

All told, the yen is a very attractive short, and has even recently given us a four-yen corrective bounce that we can use to enter positions. In addition to being a highly attractive strategy, a short yen position is also a significant portfolio diversifier, as the chart below shows (source: Bloomberg).

Yen, S&P 500 correlation

This rolling ten-day correlation shows that the yen's relationship to the American stock market fluctuates from positive to negative, and tends to revert towards zero. As far as portfolio construction is concerned, adding a yen strategy can not only enhance returns if the premise is correct, but also reduce risk. As a portfolio manager, I am always seeking strategies that do not correlate highly with each other. The yen is a very good candidate.

Equity markets tend to rise when the yen weakens, since a weaker yen is reflationary and generally equity-positive. If an investor were to short both stocks and the yen, the two would be inclined to offset each other. If the yen were to weaken (a winner for the investor in this case), stocks would rise, causing a loss in bearish stock shorts. If stocks were to sell off during times of financial stress, the yen would tend to rise, leading to a gain on stock shorts, and a loss on the yen position. This diversification lowers risk without reducing expected returns. (Note that this does not preclude investment losses under some circumstances. This is not a sure thing, just a less risky thing than doing just one or the other.)

From an investment standpoint, the yen is a very interesting addition to a portfolio, whether you are bullish or bearish. I believe the fundamentals are in place for a prolonged down move in the yen, based on its purchasing power parity, intervention status, interest rate differential, and trade patterns. If I'm wrong, my portfolio can still benefit. There's no free lunch in finance, but diversification is the next best thing.

Disclosure: I am short yen and S&P index futures.