Time To Be Long The Yen - In Times Of De-Leveraging

Includes: EUFX, FXY
by: George Dorgan

Friday's surprisingly high Japanese CPI data (only 0.1% deflation on a yearly basis) reversed the negative sentiment towards the Japanese Yen. As Christopher Vecchio explains, the stronger yen might also cause a fall in all risk-assets.

Last week Tuesday, after the bad Japanese trade balance, we increased our long yen against the euro. In "Who has got the problem? Europe or Japan?" we argued that the bad Japanese trade data is just a symptom of the euro zone weakness and the current Japanese row with China, but not a long-lasting issue.

We do not believe in the mainstream bushwah that argues the yen is overvalued.

The Bank of Japan Meeting

As usual the Bank of Japan did not fulfill the market expectations of far stronger easing or an equivalent of the Fed's "QE3 unlimited".

Recent trade history

A couple of months ago the euro traded close to EUR/USD 1.20 and the whole world was betting on its breakdown. We recommended going long EUR in August on Seeking Alpha, based on the positive European current account data.

Once the euro downtrend ended thanks to QE3, OMT and the positive euro zone current account, the common currency did not stop to appreciate against the yen and reached levels of EUR/JPY 104 and above. Many short euro positions were short-covered and pushed the common currency even further up.

Our latest mid-term recommendation, Short EUR/JPY at 102, on October 8 was lagging, but our shorts on metals and Brent are strongly winning trades. We doubled our EUR/JPY Short at 104 last Tuesday, taking some profits on metals. We wondered how the yen could fall despite its negative correlation with commodities, especially with Brent?

We target EUR/JPY levels of 97 to be reached in January.

Why are we short euro now but were long some months ago?

Fundamentally little has changed. At EUR/USD of 1.22 or 1.23 the euro was undervalued and we went long EUR/USD. But now the common currency is overvalued against the yen given that European consumers stopped spending and that European real interest rates are strongly negative.

Does the weak Japanese trade balance have an influence?

Not a lot really, for three reasons:

  1. The Japanese adjusted current account is typically 1 trillion yen better than the trade balance. The current account might be positive again.
  2. The net exports component of the GDP of a rather closed economy like Japan does not have a big influence on GDP as it does for open economies like Switzerland or Sweden. The Japanese ratio of total consumption to exports is 100 to 20, but for Switzerland it is 95 to 73.
  3. Cheaper Brent oil will reduce the next Japanese trade deficit.

We suggest that the Japanese will continue to consume. Data shows that real income and the propensity to consume is rising, even if many prices are falling. But Japan will be able to reduce the trade deficit, and consumer spending will push the Japanese real GDP growth upwards (with the emphasis on "real"). Europeans will follow their austerity path, cutting spending and still see 2% inflation and more.


The following table shows once again how surprisingly irrelevant FX rates are for trade balances over the long-term (see details). It was only after the Fukushima shock that Japan started to see a trade deficit due to higher oil imports, but it was not the stronger yen.


Export and import volume, however, depend on the exchange rate. Japanese oil imports became far cheaper since the summer of 2008 and reduced total import costs, but Japanese products got more expensive when compared to e.g. German ones. Look at the myopic discussion of a USD/JPY floor on the Financial Times.

(Source: FT)

Now compare German exports with Japanese ones valued in € between 2007 and 2012 given that the yen has appreciated by 65%.

Japanese exports may have fallen to 75% in JPY terms, yes, but they have risen to 75% * 165% = 124% in € terms.

The reader will understand that foreign exchange rates are more or less irrelevant for international trade in the long-term; the only thing central banks should do is to ensure that they do not change too quickly.

What finally drives FX rates especially in the latest decade are "Joseph" or "boom and bust" cycles in commodities or real estate caused by central banks and (ir-)rational expectations. The reader should also understand that productivity gains are often associated with a stronger exchange rate and not with a weaker one.

Is the yen overvalued?

The mainstream media continues the Keynesian talk:

"Prices have turned out weaker than the BOJ expected and the economy is slowing more than the bank anticipated, with both exports and domestic demand weakening," said Yoshimasa Maruyama, chief economist at Itochu Economic Research Institute in Tokyo.

"As such, I expect the BOJ will top up its asset-buying program by 10 trillion yen next week as it comes under pressure from the real economy as well as from politics."

"For the better part of the past decade the world's third-largest economy has been caught up in the vicious circle of price declines that discourage investment and make consumers put off spending, which in turn weighs on demand and output." (source Reuters)

The Japanese government is pressing on the Bank of Japan (BoJ) to ease further, but it does not want to inflate prices via higher taxes and reduce some debt. The state decided to spend even more and gave generous car producer subsidies, knowing that it can finance the expenditures with close to zero percent interest.

But they must know that monetary policy can never replace fiscal policy, all easing measures will have only temporary effects, similarly as QE3 has strengthened the dollar.

The Bank of Japan is a lot more independent than many might think, but they know that they cannot enforce global growth.

Lower house prices and deflation do not hinder the Japanese economy anymore. Japan has already finished big parts of the de-leveraging process and more deflation is just a reflection of slow global growth. As opposed to other central banks, they have understood that monetary policy cannot replace fiscal policy.

The government could stop all tensions with China and urge Merkel to end austerity. Only this would curb Japanese exports, stop deflation and weaken the yen.

But deflation has some positive aspects, too. Even if the USD/JPY has fallen by 5%, from 84 to 80 since September 2010, deflation allowed Japanese companies to produce at lower costs (according to producer price index, PPI, or the Japanese equivalent CGPI):

  • The US PPI was at 2.1% YoY in September 2012 and 6.9% in September 2011. Hence US products are 9.1% more expensive than in September 2010.
  • Thanks to falling prime material prices, the Chinese PPI has fallen this year by -3.6%, but it was up by 10% in September 2011. The yuan however, has appreciated against the dollar by 6.6% since September 2010. In total Chinese products are 13% costlier in US$ terms than two years ago.
  • Japanese CGPI is down this year by 1.4%, last year September it was up 2.6% on year basis. With the 5% increase of the yen Japanese goods are 6.2% more expensive in dollar terms than they were in September 2010.

Consequently the yen is currently undervalued, when compared to September 2010.

Ever cheaper Japanese production costs are reflected in the long-term channel. The channel shows more or less the purchasing power parity based on the PPI and can be considered as the real mean-reversion for currencies.

PPP-PPI reflected in long-term EUR/JPY channel

Given that neither the ECB nor the Fed will hike interest rates that soon, there is absolutely no reason to assume that the long-term channel of the EUR/JPY will be broken, like the arrow above might indicate. There will be no stronger growth in Europe than in Japan.

HSBC puts it in this nice chart:

HSBC Yen Reality versus excitement (Source: FT)

The Fed is currently financing another debt-based consumption rush. This will only strengthen the Japanese trade balance and give another push to Japanese growth like it did in Q1/2012. The Japanese will continue to keep their money at home and to finance the government debt.

We are not coming back to the carry trade era that systematically exploited the yen for financing of foreign investments.

Definitely not, as the Fed and the ECB have printed some money; one reason for this was for these central banks to avoid deflation, or let's say, to avoid becoming Japan.

US laws allow debtors to leave the indebted home, therefore the private de-leveraging is in a far more advanced state in the US than it is in Europe. The crisis of the European periphery began in full in the summer of 2011; the US is already four years ahead, but due to restricted credit conditions not out of the trouble by far.

For us it's a clear case: EUR/JPY and probably also USD/JPY will fall in the next months.

Investment recommendation in terms of ETFs

Be long the Japanese yen (NYSEARCA:FXY) and short EUR/USD (NYSEARCA:EUFX).

Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article.

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