Samurai Doldrums

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Includes: DBJP, DEWJ, DXJ, EWJ, EWV, EZJ, FJP, FXJP, FXY, GSJY, HEWJ, HFXJ, HJPX, JEQ, JPN, JPNH, JPNL, JPXN, JYN, YCL, YCS
by: Ivan Martchev

The 1929 pre-crash high in the Dow Jones Industrial Average was 381. Less than three years later, it had retreated 89% to 41. By that yardstick, the Japanese came pretty close (-82%) when the Nikkei 225 Index, which topped out in December 1989 at 38,900, fell down to 6995 during the nadir of the 2008 Crisis. The biggest difference is that it took Japan nearly 20 years to fall over 80% vs. just three years in 1929-32.

Japan Nikkei 225 Stock Market Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

How long did it take for the Dow Industrials to overtake its pre-Great Depression high? Fully 25 years. The Dow made its first fresh all-time high in late 1954 and has not looked back since then. By now, it is nearly 28 years from the all-time high of the Nikkei 225 Index in December 1989 and the Nikkei 225 benchmark index of Japanese blue chips is still about 42% below its all-time high. Clearly, there is something wrong with Japan, especially given the recent calls for a major breakout in Japanese stocks.

Can the Nikkei 225 go higher? It sure can, given that Prime Minister Shinzo Abe won a third term to lead the government last month in a snap election and the present governing coalition now has a two-thirds supermajority in parliament, which gives him the opportunity to change the Japanese constitution. You can see the excitement in the Nikkei 225 Index which is diverging notably from the USDJPY cross rate.

Japan Nikkei 225 Stock Market Index versus Japanese Yen Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Why is there such strong correlation between the yen/dollar rate and the Nikkei 225 Index? Large Japanese corporations export more than U.S. multinationals, so it is not uncommon that 70-80% of earnings come from abroad. The lower the yen the more money they make when they repatriate profits.

The driver of the yen has been the Bank of Japan, which since 2013 has carried out the monetary policy arm of Abenomics - a QE (quantitative easing) program that is 3X more powerful than what the Fed's was at the heyday of quantitative easing in the U.S., relative to the size of the Japanese economy.

Japan Central Bank Balance Sheet Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The way the BOJ is going, it may end up owning the Japanese bond market and then some, given that in the Japanese QE program there is room left to buy equities, unlike the QE operation in the U.S. For all intents and purposes, the rally in the Nikkei feels manufactured - as it is not due to a domestic saving and investment cycle, but rather on central bank monetarist engineering.

While I think the Nikkei 225 Index can go higher as the yen feels pressure and the BOJ is pressing pedal to the metal on their QE policies, this is not a self-sustaining dynamic as Japan has negative population growth which, if it continues, virtually dooms Mr. Abe's policies to failure as with shrinking population Japanese GDP is doomed to shrink. This is one of the major reasons why Germany has had an open-door policy to Syrians, since the influx of refugees has reversed Germany's long-term population decline.

Japan Population versus German Population Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This population decline that was foreseen by many experts 20 years ago also suggested that the deflation that has plagued the country was likely to persist, as it sure did. It also led to the highly interesting monetary phenomenon of the Japanese yield curve disappearing, or the difference between short-and long-term rates hovering near zero for extended periods of time.

Japanese Interest Rate versus Japanese Ten Year Government Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I know that if the BOJ leaves the JGB market the Japanese yield curve will re-steepen somewhat due to the supply of JGBs, but fundamentally we have a much bigger problem than monetary policy. Unless the Japanese figure out a way to encourage more immigration, which is a taboo for their homogenous society, or install 3D printers at the Bank of Japan to produce babies, they can't overcome their demographic choices. If the Nikkei rally is driven only by pushing the yen lower, then it is ultimately doomed to fail.

The Yen Wild Card

It is also well known among traders that under normal conditions the USDJPY cross rate tends to follow BOJ policy - which means to weaken - but under stress in global financial markets it turns into a fish swimming against the current and moves higher. This is because of the huge yen-funded carry trades that result in a synthetic short against the yen, which creates a giant short squeeze in times of global turmoil.

This is the primary reason why the USDJPY rate moved from 125 to 100 from 2015 to 2016. This is why if the Chinese chose to do a hard (overnight) devaluation to the tune of 20%-40%, similar to what they did in 1993, I think the yen will overshoot to the upside and appreciate below 100 to the dollar. We are not there yet and such a move is impossible to predict accurately, but I think it is coming in 2018 or 2019.

Upon such a Chinese devaluation, I expect both the yen and the dollar to move significantly higher at the same time, which is not something we see often in global markets. Until that happens, the dollar is likely headed higher and the yen lower.

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