The Japanese yen is likely to appreciate strongly vs. the U.S. dollar on any formal announcement of further quantitative easing by the Federal Reserve. The USD/JPY pair has been weak since the days of the Greek default that sent capital flying out of Europe. As much as the USD gained during that period, the yen gained even more. Both countries saw an incredible amount of money flow into their bonds as yields were pushed to record lows. This was augmented by both the Federal Reserve and the Bank of Japan running open market operations buying up the long end of the yield curve, 10 years and higher.
This appreciation of the yen vs. the dollar ended in late July when the EUR/USD exchange rate bottomed at $1.203 on July 23. Since then, bond yields for both U.S. treasuries and Japanese bonds (JGB) have been rising. Yields peaked after a round of short-covering, but then bond prices began rising again in late August. After the Jackson Hole speech by Bernanke and the unveiling of unlimited QE by the ECB and the Federal Reserve, the bond markets confirmed what was happening in the currency markets. Europe and the European Union has been backstopped in the medium term, and the fear premium has reversed capital flows out of the U.S. dollar and into the euro. What needs to be noted, however, is the reemergence of the difference in demand between U.S. treasuries and Japanese government bonds. This is consistent with the breakdown of the USD/JPY pair below ¥78.1 on Tuesday, Sept. 11, as the Bank of Japan has made it clear that it is reconsidering its counter-cyclical borrowing and spending policies for the long term.
The Bond Dilemma
The decision by the FOMC and Chairman Ben Bernanke to engage in open-ended quantitative easing means that the Federal Reserve knows the situation behind the headlines is much worse than it appears to be. At that point, selling any long positions in U.S. Treasury ETFs like the iShares Barclays 20+ Yr Treasury Bond ETF (TLT) or shorting it would be a very safe long-term trade. The weekly close above 3.0% on the 30-year Treasury bond is a good medium-term signal of what the real sentiment in the market is toward U.S. treasuries. There will not be a dramatic collapse of the Treasury bond market. There are too many people who have a vested interest or who are bound contractually to move their money out of these instruments as investment vehicles. But the fundamentals are in place and the technicals are lining up with them.
At this point, the long U.S. Treasuries trade is nearly as crowded as the short euro/long U.S. dollar trade. But, all bull markets end and the U.S. bond market has been in a bull trend since 1980. We are certainly nearer the end of it than the beginning. Are we at the moment in time when we can finally write the last chapter, or does the Fed have one more ace up its sleeve?
This move into U.S. bonds has been so strong that it has spilled over into corporate bonds. The iShares IBoxx $ Investment Grade Corporate Bond Fund (LQD) has been pushed up ~11% since the beginning of 2011, with a drop in yield from 4.8% to a current yield of just 3.95%. LQD's assets under management have risen an astonishing $9.0 billion, or 75%, to $20.91 billion.
For those looking for cash flow, this has been a great trade. But, again, if the U.S. is headed for a fiscal cliff in 2013, wouldn't some of the emerging market ETFs make more sense? Some, like those of Thailand (THD), Malaysia (EWM) and Singapore (EWS), are paying comparable if not better dividends. They will benefit from the coordinated QE since their trading partners in the West will continue to limp along at present low nominal growth terms and not completely implode, which has been the worry overhanging their markets for months, muting their rallies.
The truth is that the problems for the banks that hold the debt of the sovereign nations of the European Union as well as many of the states of the U.S., which are also teetering on the edge of bankruptcy, can only be forestalled by more QE from the central banks of the U.S., Europe, and others. QE is not a solution but rather a soporific, more akin to morphine than any cure. The issue going forward is going to be who is going to do the heavy lifting from here. The Bank of Japan, by throwing in with China and only mildly extending its existing programs, has made it very clear that it is not going to do it going forward. Whether the political upheaval in China spills over into Japan over the Senkaku islands remains to be seen.
The ASEAN Connection
The burgeoning relationship between China and Japan to use each other's currency in their bi-lateral trade, as well as holding each other's bonds in reserve, will put a floor under the exchange rate of the yen. Japan can and will act as the de facto reserve currency for the ASEAN/Pacific Rim region in the coming years, and the demand for yen and JGBs will continue to rise. If China overplays its hand with respect to Japan then it could get very interesting, but that is the subject for a different article detailing U.S. foreign policy initiatives to drive a wedge between the Asian economies. In May, the BoJ let it be known that foreign ownership of JGBs reached its highest level in more than 10 years at 8.5% of the total outstanding. Appetite for Japanese debt, given the strength of the yen and the relative security of JGBs, will continue to rise as Southeast Asia's trade becomes more regional, a trend that is already well under way.
The countries of ASEAN (Singapore, Malaysia, Thailand, Vietnam, Indonesia, Philippines, Brunei, Cambodia, Laos, and Myanmar) and their major trade partners (China, Japan, South Korea, and Taiwan) will form a regional trading block over the next decade that will dwarf North America and Europe. The Japanese yen will be the transitional reserve currency for the region while China sorts through the issues of fully opening up the yuan for convertibility.
The QE announcements did nothing to change the relationship between the yen and the dollar -- if anything, they codified the long-term strategies of both central banks. The yen has been appreciating vs. the dollar and it will continue to do so, which is precisely what the Fed wants. No one fights the Fed and wins. If investors need a long-term signal as to when to buy the CurrencyShares Japanese Yen ETF (FXY), it would be after a weekly close below 78.1 on the USD/JPY cross. That can and should happen anytime now.