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Wednesday November 18, 2009 - 15:24:04 GMT
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Oh yen, we wonder when…

Key News
Mexico and Colombia plan to sell Samurai bonds, joining Poland and the Philippines in turning to Japanese investors for funding as governments grapple with budget deficits.  (Bloomberg)
South African retail sales fell an annual 5.1 percent in September, more than economists forecast. (Bloomberg)
U.S. mortgage applications fell last week, with demand for home purchase loans dropping to a 12-year low even as interest rates on 30-year loans fell to their lowest level in six months, data from an industry group showed on Wednesday. (Reuters)
Builders in October unexpectedly broke ground on fewer U.S. houses. (Bloomberg)
 
Quotable 
“Nobody realizes that some people expend tremendous energy merely to be normal."        
     Albert Camus

FX Trading – Oh yen, we wonder when…
We are taking a little break today.  In place of my usual ramblings, below is an excellent article by Chris Fournier and Yasuhiko Seki of Bloomberg laying out the case for a weak yen based on the very ugly set of economic fundamentals and debt picture facing Japan.
 
Maybe USDJPY goes lower as institutional money is repatriated back into Japan given rising domestic risk.  But sooner or later we think Japan’s economic fundamentals will feed into the currency in a big way.  [Chart not available in text format.]

Nov. 16 (Bloomberg) -- The yen is poised for its worst tumble since 2005 as doubts about Japan’s fiscal footing double the cost of insuring its debt. 
 
The price of hedging against losses on $10 million of the country’s bonds with credit- default swaps soared this month to as much as $76,160 a year from $37,000 in August, as the new government planned record spending and borrowing even with tax revenue falling. The rise in debt protection costs contrasts with that of the U.S., where prices have fallen to about the lowest in a year amid unprecedented issuance. The difference in prices reached the widest ever on Nov. 9 after Japan’s debt grew to almost twice the size of the economy. 
 
“The Japanese fiscal situation is horrific,” said Richard Benson, who helps oversee $11 billion of currency funds at Millennium Global Asset Management in London. “We went short the yen against the dollar and the euro about a month ago” and then turned “more aggressive” on the trade as credit-default swaps rose and investors dumped Japanese bonds, he said, declining to specify the firm’s gains. Selling yen for euros and dollars would have returned as much as 4.3 percent since Oct. 1, data compiled by Bloomberg show. 
 
Japan’s unprecedented debt, near-zero benchmark interest rate, ballooning budget deficit, sinking savings rate and worst postwar recession all are aligned against the yen. 
 
Standing Alone 
 
The Bank of Japan will stand alone in keeping borrowing costs at near-record lows next year to revive the Group of 10’s fastest-shrinking economy, making its assets less attractive to investors, median Bloomberg survey predictions show. The world’s second- biggest economy last year at $4.9 trillion will contract 5.7 percent in 2009, compared with an average of 2.5 percent for the nine other largest economies, according to median forecasts. 
 
“We can’t rule out the possibility of capital flight away from Japan due to its deteriorating fiscal position,” said Yuji Saito, head of the foreign-exchange group in Tokyo at Societe Generale SA, France’s third-largest bank. 
 
The yen has outperformed all 171 other currencies tracked by Bloomberg over the past two years, appreciating 24 percent to 89.45 per dollar today. The currency is up 12.9 percent from a five-month low on April 6, and has gained 1.3 percent this year. Now, 34 of 38 strategists in a Bloomberg survey see it falling by June 2010, including Landesbank Baden-Wuerttemberg, the most accurate of 46 forecasters in the six quarters ending June 30. 
 
Steep Tumble 

The Stuttgart-based bank predicts a 9.9 percent decline to 100 from 90.09 at the end of October, which would be the steepest eight-month drop in four years. Goldman Sachs Group Inc. in New York forecasts 105 in 12 months, a 14.8 percent slide from the Nov. 13 close. 
 
Option traders are the least bullish on the yen since July 2007 after the spread between demand for three-month contracts to buy and sell the currency narrowed by the most ever in the past year, so-called risk-reversal rates show. 
 
“Declines in risk reversal rates suggest underlying strong pressure to sell the yen,” Societe Generale’s Saito said. 
 
Outstanding government loans and bonds totaled a record 864.5 trillion yen ($9.6 trillion) on Sept. 30, making Japan the world’s most indebted nation. That’s 181 percent of gross domestic product, up from 94 percent a decade earlier and the most among the 30 countries of the Organization for Economic Cooperation and Development, which averages 79 percent. The U.S. has about $7 trillion of marketable debt outstanding, or about 50 percent of its GDP, according to government data. 
 
Increased Unease 
 
While credit-default swaps indicate less than a 6 percent chance the world’s second- largest foreign-reserves holder will default, they show increased unease with the debt’s quality. 
 
The five-year contracts cost 67.42 basis points, or 0.6742 percentage point, of the sum covered a year. Of 20 developed countries tracked by Bloomberg, only Greece, Ireland, Spain and Italy have pricier swaps. Insuring the debt of Slovakia and Slovenia, which have the same credit ratings as Japan or worse, is cheaper. 
 
Hedging against losses on U.S. bonds cost 27.5 basis points on Nov. 13, down from 100 on Feb. 24. The U.S. will sell a record $2.1 trillion in Treasuries this year and $2.5 trillion next, according to London-based Barclay’s Plc, one of 18 primary dealers that trade with the Federal Reserve. Government bond yields are used as a benchmark for companies such as Shiseido Co., Japan’s biggest cosmetics maker, and brewer Kirin Holdings Co. as they sell debt. 
 
‘Difficult’ Situation 
 
“It’s not really a question of default” by Japan, said Carlos Leitao at Montreal-based Laurentian Bank Securities, the second-most accurate economist in a Bloomberg survey last year. “It’s more the situation becoming so difficult, the government is forced to adopt more restrictive fiscal policies to bring deficits under control. That would further slow the economy.” 

Finance Minister Hirohisa Fujii said on Nov. 10 that “maintaining the trust of investors in the government bond market is our priority” because “the most pressing issue we have to bear in mind when we outline next fiscal year’s budget is that government bond yields are surging.” 
 
International demand is already faltering. Foreign investors have sold a net weekly average of 130 billion yen in Japanese bonds this year, after averaging 94 billion in purchases the prior five years, Ministry of Finance data show. 
 
Yields on 10-year bonds, which reached 1.485 percent this month on an intraday basis, the highest since June, may rise toward 1.7 percent, said Kazuto Uchida, chief economist for Bank of Tokyo Mitsubishi UFJ Ltd., Japan’s biggest lender. 
 
Interest Expense 
 
Japan will spend 10.2 trillion yen on interest payments this year, or 26.2 percent of tax revenue, up from 18 percent in 1990 and 18.9 percent in 2004, JPMorgan Chase & Co. of New York estimated in an Oct. 21 report. The percentage may rise to 36.8 in 2014 and 73.9 in 2019, the bank estimated. 
 
Domestic buyers will shore up demand for the securities, limiting yield increases, according to Koichi Kurose, chief strategist in Tokyo at Resona Bank Ltd. 
 
“The sell-Japan campaign is not likely to become a mainstream move, given the fact that Japanese investors hold over 90 percent of outstanding debt issued by the government,” said Kurose, whose employer is part of the nation’s fourth- largest banking group. “In a country like Japan, where there’s a stable current-account surplus, rising debt issues won’t push up yields perpetually.” 
 
Japan almost always exports more than it imports, current- account data show. That broad trade measure shows its surplus rose 0.2 percent to 1.57 trillion yen in September from a year earlier after also rising in August -- the first two straight increases since early 2008, the Finance Ministry said Nov. 10. The surplus allows Japan to finance deficit domestically so it doesn’t have to rely on overseas lenders. 
 
Saving Less 
 
JPMorgan said in its report that Japan’s dependence on domestic bond buyers may hurt demand. Such investors owned 93 percent of the government’s debt as of December, according to a ministry report. Because the Japanese are saving less, they will buy fewer bonds and drive yields up, the bank said, predicting that average families will be squirreling away none of their income within five years, down from about 17 percent in 1980. 

“A reasonable estimate that falling savings pushes interest rates higher” by 2 percentage points “would quadruple debt service costs in 10 years,” JPMorgan said. 
 
Vice Finance Minister Yoshihiko Noda estimated last month that bond sales may hit 50 trillion yen in the fiscal year that started April 1 due to slumping tax revenue, up from the unprecedented 44 trillion estimated in a budget that called for spending a record 102.5 trillion yen. 
 
Falling Revenue 
 
Tax revenue from April 1 through Sept. 30 totaled 10 trillion yen, 24 percent less than at the same point in the prior fiscal year and the least in 11 years or more, Finance Ministry statistics show. 
 
Japan’s deficit “is one of the most significant negative factors” weighing on its credit rating, said Takahira Ogawa, Singapore-based director for sovereign rankings at Standard & Poor’s. S&P isn’t considering changing its “stable” outlook for Japan’s AA international-debt grade, the company’s third highest, he said. 
 
Fitch Ratings may review its AA- grade on locally denominated debt if the country violates its pledge to keep next fiscal year’s bond-issuance below 44 trillion yen, said David Riley, the firm’s head of sovereign ratings in London, in a Nov. 10 Reuters Television interview. 
 
“Economic conditions point toward a possibly extended period of deflation,” Riley said in a Nov. 10 statement. “Should this happen, it will represent a material risk to the public debt outlook.” In a Nov. 13 e-mail, he said he “cannot comment” on what sum might “trigger a rating action.” 
 
Japan Deflation 
 
Consumer prices in Japan have fallen from a year earlier for eight consecutive months through September, including a July’s unprecedented 2.3 percent drop. Median quarterly forecasts predict that trend continuing through mid-2011. 
 
“If Japan’s sovereign debt loses its current rating, it would also lose its status as a safe- haven asset,” said Soichiro Mori, manager of foreign-exchange promotion at FXOnline Japan Co. “Foreign investors definitely won’t be motivated to hold such debt.” 
 
The DPJ won power on Aug. 30 by pledging to boost spending and cut taxes, unseating the Liberal Democratic Party, which reigned for all but 10 months since 1955. 
 
Postal Service 
 
Concern about DPJ fiscal policies worsened when Prime Minister Yukio Hatoyama, 62, appointed a former finance ministry civil servant, Jiro Saito, to head the postal service, according to investors such as Makoto Kojima, general manager of global markets at SBI Liquidity Market Co., a unit of financier SBI Holdings Inc. The party vowed to curtail bureaucrats’ power by opposing so-called amakudari, the practice of giving them jobs at state-run companies. 
 
The Nikkei 225 Stock Average has lost 7.4 percent in yen terms since Aug. 28, the trading day before the election, making it one of the six worst performers of 89 primary equity indexes tracked by Bloomberg. 
 
The yen’s value “is not consistent with the underlying fundamentals, and that’s a huge opportunity,” said Michael Hasenstab, who oversees $45 billion in fixed-income assets for Franklin Templeton Investments and is using forward contracts to bet on the yen’s decline. “The yen is very vulnerable.”
 
Jack Crooks
Black Swan Capital LLC
www.blackswantrading.com 
 
 
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