Japan: The Canary In The Currency Mine

Includes: EWJ, FXY
by: Larry Trefz

For almost four decades, Japan was the world's second largest economy. Japan lost that position in 2010 when China pulled ahead and took second place on the world's economic stage.

In the late 1980s and early '90s, Japan experienced a real estate and stock bubble of massive proportions. This was partially made possible by the fact that Japan did not have to spend any significant amount of money on national defense for several decades in the aftermath of WWII.

The authorities in Japan attempted to manage the bust phase of these bubbles through government spending and monetary policy. The result has been a debt to GDP ratio of over 200% and a deflationary time-period that has lasted for more than two decades.

Japan's 10 year Government Bond Yield:

Historical Data Chart

Japan's Debt to GDP:

Japan has an aging population and very low birth rate which makes the their economic situation more difficult for the long run.

Japan's current prime minister Shinzo Abe has vowed to fight this long-term deflation. The plan is to carry out unprecedented monetary easing measures, in an attempt to weaken the yen. The hope is that this action will break the malaise and reignite the Japanese economy.

The big question is; Will it work this time?

Japan was the inventor of the modern version of quantative easing (QE) back in 2001. It is obvious that the results of the Bank of Japan's efforts over the last decade have not produced the desired results as the bank has had plenty of time to demonstrate its tactics.

The thought with many monetary authorities is that Japan was on the right track with the QE programs but simply did not go big enough to produce the desired results.

Now, Japan has decided to change that and has recently rolled out a plan to ease at the rate of $75 billion per month for a total of $1.4 trillion dollars.

The plans for these massive monetary easing actions have resulted in the yen weakening dramatically over the last few months. This follows decades of the yen strengthening--deflation.

U.S. Dollar/Japanese Yen:

Historical Data Chart

The yen trade has been huge as of late, as many major hedge funds have jumped on the band wagon and ridden the yen's slide. Will the move last? Or, will it turn out to be a bump in the longer run of a huge deflationary story?

Large monetary easing actions are bound to have unforeseen consequences, as warned by the Bank For International Settlements in its 2012 annual report.

The monetary easing actions of the Federal Reserve over the last few years have shed some light on how the newly created money affects the nation's broader economy.

The cash injected by the Fed flows through specific channels in the financial system -- first to the money center banks, from the money center banks the hope is that the money then trickles down through the regional banks and businesses where it will eventually stimulate the broader economy. In practice, the liquidly injected by the Fed has the tendency to find its way into more specific areas rather than a broad-based even distribution. One of those areas that seems to have benefited the most is the U.S. stock market.

As the U.S. is now several years into very aggressive monetary easing actions, we can now start to discern more clearly where these liquidity flows go. It appears that wages and incomes are not being positively affected in proportion to assets and commodities.

In other words, the central bank's newly created money is injected at the top of the economy--into the money center banks. This props up the prices of assets and commodities but does not equally affect wages--especially on the lower end. This creates an imbalance, which if taken too far, will likely cause social unrest as those in poverty will be less able to afford the necessities.

It is interesting to note that in January 2013, Japan moved to cut back on welfare programs by 6.5%, these cuts will start in August. Actions such as this may indicate that the Japanese government does not adequately understand the potential for imbalance in the broader economy.

Conclusion: In my view, the odds of Japan achieving its goal of escaping deflation will largely be determined by whether its leaders recognize the imbalance they are creating before it is too late.

In order for real inflation to take place, the people have to have enough money to spend to the point where they can bid prices up. The opposite is when people have less and less money and contract their spending as a result (deflation).

For reference; the size of Japan's newly proposed monetary easing action ($75 billion per month) is about three times that of the current U.S. rate of easing ($85 billion per month), as Japan's economy is about one-third the size of the U.S., as measured by GDP.

Should the Japanese authorities continue on their current path, without addressing the issues of imbalance as mentioned above, I would watch for signs of social discontent on the lower end of the population's economic spectrum. Should this start to be evidenced, I would look seriously at shorting both the Japanese stock market and going long the yen.

In my view, too many monetary policy makers, as well as investors and traders get hung up on the technical parameters of the markets at the expense of the bigger picture, which is right in front of them. The markets are made up of the people who participate in them (willingly or unwillingly) with all of their biases, emotions, strengths and weaknesses.

It is also my view that at the end of the day, people are much more likely to lead markets than the other way around. It would appear that Japan's policy maker's may be in the mode of thinking that markets can lead the people.

Cart-before-the-horse comes to mind but time will tell how it works.

ETFs that can be used to trade Japan's markets include: (NYSEARCA:EWJ), (NYSEARCA:FXY).

Disclosure: Nothing in this article is to be taken as professional financial advice, nor is it a solicitation to buy or sell any type of securities. All financial decisions are your own, seek professional advice before taking action.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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