No Japanese Surrender

Includes: FXB, FXY, GBB, JYN, YCL, YCS
by: Polemic Paine

Originally published on April 7, 2016

It might not have escaped your notice that the Japanese yen is screaming higher. Which may be odd, as it's usually a counter-carry currency that goes up in times of stress as the money comes home. Is there carry stress out there? EM has been performing and credit has rallied, so on the face of it there isn't a reason to unwind your carry trades other than they are sinking underwater due to the move in the yen itself. This is a circular reinforcement argument which, for money management rules, is just as valid as a decrease in yield differentials. Capital losses versus interest losses. Carry trades are inevitably saw-toothed in nature as they creep upwards looking for interest differential and collapse on self-reinforcing capital preservation trade unwinds. Hence, the inevitable skew in the risk-reversal option pricing. On the carry trade argument, the move in the yen looks like a carry capitulation.

The major driver to everything yen is the great BoJ Abenomics experiment. Here, Abenomics are the CERN of monetary policy experimentation. It is the biggest and boldest experiment into discovering how the monetary universe really works. Observations on the path of the yen would currently suggest that there is a need for monetary dark matter to explain the difference between theory and observed reality.

On a pure printing of money basis, a yen's value is a function of the number of yen in circulation versus the total net worth of all assets denominated in yen. Econ 1.0.1 says the more yen in circulation against fixed-valued assets, the lower the yen is valued against those assets. Abenomics is focused around yen creation to cause it to devalue. So why is the yen screaming higher especially against the USD, where the opposite is more likely to be occurring? It really depends on what you do with your printed money. Parking it back into your own hoarding systems just doesn't work. It needs to get out there into the economy. One way would be to lend to US banks or invest directly in offshore assets, other overseas bonds, and park them in a form of sovereign wealth fund. The Japanese Post Holdings has always been a quasi-state institution that, even after partly IPO'd, must have enough state interest to still be able to cover foreign asset ownership.

Of course, if they wanted to bypass all the pretence, they should just print yen, sell it for euros and buy German car companies. Nothing like reversing your currency, countering deflation and acquiring your competition, all effectively for free. It may sound nuts, but if someone is seriously willing to take your newly minted money, which is just a movement of electrons in the world of electronic banking, and exchange them for huge tangible assets, then I would bite their hand off.

Whilst the yen has been strengthening and the Nikkei correspondingly falling, questions are being asked as to whether monetary policy has reached the end of the road. Though I may agree that the policy embarked upon in Japan will not work when to comes to generating growth, it will, if enough is thrown at it, cause inflation, even if inflation doesn't lead to growth. We just need the dam in the transfer system to breach, as currently it's as though the toilet has been flushed, but the U-bend is blocked.

Will Abe give up on his policy? Will the Japanese, to whom "face" historically and culturally has been something that has always had to be saved, be willing to accept that they have been wrong? Instead of surrender, I would expect them to go berserk (in the true meaning of the word) and go madly into attack. Considering this and the path of the yen so far, together with their world-leading experimentation into monetary policy, I would strongly suspect that they will go all in and aggressively buy equities. Abe's Alamo.

For this reason, I am buying Nikkei, JPY hedged, as it will benefit directly and via a retrace in the yen caused by a shock-and-awe action. Considering the potential move down, before up again on timing, I am looking at options too.

Now, to touch upon contiguous market dynamics. The yen's fall has now picked up market attention, and while correlation with "rest of the world" stocks has been low recently, when we hit acceleration mode it adds to the general mood of concern. Everything "risk" today looked awful. Copper fell to bits, having breached the support we've been using for a while (yes, I got stopped out of longs there).

Oil fell, the single European bellwether of DB stock fell and we ended up with SPX plumbing the lows. But interestingly, holding that 2032 area that has been support/resistance congestion for a while. Why interesting? Because the markets felt as though they were going to accelerate to the downside and didn't.

The UK's FTSE has been outperforming other markets on a % index basis despite the commodity sell-off, but much of this can be explained by the GBP's fall (which is being blamed on fears over the EU referendum) and the GBP valuation of UK-listed non-UK dependent businesses. The GBP's fall is, meanwhile, making the UK even more competitive and relieving any disinflationary pressures. So here's the irony: What Abenomics has failed to do in Japan over years, the UK has managed to achieve in only weeks by suggesting it may leave Europe.

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