A Short Case for the Japanese Yen

Includes: FXY, JYN
by: Daniel Moser

The Japanese bear yen train has not left the station yet, although boarding is taking place. In case you haven’t followed the story about the Japanese scenario, The Economist has a nice little article summarizing the problems with the Japanese economy.

They summarize three big problems facing the Japanese:

The first concerns government bonds. The state has for years relied on domestic savers to buy them. But as Japan’s people age and run down their savings, they will have less money to invest in government bonds. An IMF paper calculates that even if the savings rate remains close to where it is now, gross debt may exceed gross household assets by 2015. Japan might then have to rely on foreigners to finance its debt, and they will want much higher returns. That will, at the very least, provide an acute reality check. Goldman Sachs says some foreign investors are already positioning themselves for a ‘meltdown’.

The USD/JPY cross rate is starting to break out (to use technical terms), and according to some, including Dennis Gartman, this represents a “WATERSHED shift” in the currency market. The question remains whether this breakout is a false move or the actual beginning stages of a major trend change in the currency markets.

Personally, I am on the side that this breakout represents the beginning of a multi-year trend towards a weaker yen.

The Economist article goes on to say:

The second, more immediate problem [of] deflation. Falling prices may have helped the government by providing its bondholders with invisible gains, but in other ways deflation is a menace. It pushes the debt-to-GDP ratio inexorably higher. As expectations of deflation become entrenched—35% of Japanese expect prices to be the same or lower in five years’ time—they will continue to depress consumption.

Japan has quite the industrial empire. However, the third problem noted by The Economist is that “despite the recent pick-up in global economic activity, Japan cannot count on foreign demand being strong enough for it to sustain export-led growth, as it did in the past decade.

Without a stronger domestic economy, growth will not generate enough tax revenue to reduce the debt. One ominous sign is that in the 2010 budget implemented on April 1st, borrowing, at ¥44 trillion ($468 billion), is for the first time forecast to exceed tax revenues, at ¥37 trillion.”

The yen is poised to decline against the USD over the medium to long term time horizon, and that is actually a good thing for the Japanese economy. According to the WSJ:

For every one-yen rise in the dollar above 90, Canon Inc., the Japanese maker of digital cameras and printers, says its operating profit will increase $91 million. Sony Corp. says its operating profit would increase $11.1 million.

Koji Endo, an analyst at Advanced Research Japan, estimates a rise or fall by one yen against the dollar either lifts or reduces Toyota Motor Corp.'s annual operating profit by 25 billion yen ($267 million). To put that in perspective, a 1.5-yen slide against the dollar is enough to erase Toyota's expected 20 billion-yen operating loss for the fiscal year that ended on March 31. A one-yen move either boosts or reduces Honda's annual operating profit by 15 billion yen and Nissan's by 10 billion yen.

The WSJ article goes on to say that

The yen's slide also helps Japan's exports to China, an increasingly important market for Japan. China has maintained a de facto peg against the dollar since July 2008, so a drop in the yen versus the dollar is also a drop against the Chinese yuan. Counting the U.S., China and Hong Kong, which also maintains a peg to the U.S. dollar, nearly 40% of Japan's exports go to markets where the dollar's level is a critical factor in determining competitiveness.

It is clearly in the national interest for Japan to have a weaker yen, and quite frankly government officials have proclaimed this viewpoint publicly on several occasions throughout this recession.

From a slightly different perspective on this trade idea, the timing of shorting the yen might be a little early but there is an added catalyst that could give early investors some handsome rewards. In the context of carry trading activities both countries (the U.S. and Japan) are effectively at 0% interest rates which implies no significant interest rate carry benefit being short the JPY or the USD against one another.

However, in my estimation, the U.S. is much more likely to raise the federal funds rate before the Bank of Japan. If my estimation is correct, when the FOMC does move to increase interest rates, what might start out as a small trickle of traders interested in playing the modest carry will likely evolve into a flood of funds playing carry strategies which will send the yen even lower.

The bottom line the Japanese yen represents a superb short position for the medium/long term trading position.

Disclaimer: I am well aware I am not the first person to write on this topic. There are many people and investment institutions which have done substantial work on this topic and be gracious enough to allow it to be released.

Disclosure: Author is short the JPY against the USD

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