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Tuesday April 6, 2010 - 14:44:44 GMT
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Japanese yen Double Whammy: QE from the BOJ and Exports to the US

Key News
•    Greek government bonds fell amid speculation that a plan for European Union and International Monetary Fund assistance in reducing the nation’s budget deficit may falter. (Bloomberg)

Quotable – On Greek debt
“Every few years, investors get all enthusiastic about Japan. This time the recovery is for real, they argue. This time real change is afoot. This time buy yen-denominated assets and don’t look back, they conclude.

“The end result tends to be disappointment. This latest episode of euphoria is likely to be more of the same.

“It brings to mind Charles Schulz’s ‘Peanuts’ cartoon: Charlie Brown, Lucy and the football. Time and time again, Lucy convinces Charlie Brown she’ll hold the ball for him to kick only to yank it away at the last second. Every time, he lands flat on his back, pondering his gullibility.” —William Pesek
FX Trading – Japanese yen Double Whammy: QE from the BOJ and Exports to the US

Playing for Japanese yen weakness is one of our favorite long-term trades at Black Swan Capital; besides being short the euro against any other currency with a pulse.  The yen has started to weaken against the pack—finally.  But there are two reasons why we believe this game is only just getting under way.

1)    Quantitative easing on the way, solidifying the yen’s rightful place as the world’s carry trade currency, and
2)    Rising exports reduce relative Japanese country risk, adding to risk appetite for local Japanese investors i.e. to move money offshore

From Robert Feldman, a long time Japan watcher, and very smart man, who toils away at Morgan Stanley [our emphasis]:

“The lower bound on nominal interest rates has been a crucial problem for Japan. As prices decline, the real interest rate has risen, choking off investment, worsening growth and worsening deflation even more. For Japan to return to stable, self-reinforcing growth, it is essential to break the vicious circle of lower prices, higher real rates, lower investment, yet higher output gaps, yet lower prices, etc.

“Breaking the cycle is far from impossible. Indeed, Japan's own economic history of the last 20 years suggests the very actions that are needed. Policymakers need only recognize and repeat what went right under BoJ Governors Hayami and Fukui, and replicate it. Should they do so, equity markets would likely rise. Moreover, a sustainable fiscal position would be closer, since growth would be more sustainable.

“Japan's own recent history hints at what needs to be done today. Once the BoJ recognized that the rate hike of August 2000 was premature, it reverted to ZIRP, but added an important element, the so-called ‘time axis'. On March 19, 2001, the BoJ announced "New Procedures for Money Market Operations and Monetary Easing", and shifted the target for monetary policy from the overnight call rate to the level of current reserves at the BoJ. In addition, the BoJ stated that "The new procedures for money market operations continue to be in place until the consumer price index (excluding perishables, on a nationwide statistics) registers stably at zero percent or an increase year on year". There was a simultaneous shift to quantitative easing (QE) and use of a time-axis.

“This initiative was successful. As the reforms of the banking system kicked in, as other structural reforms were adopted, and as growth in China and other trading partners accelerated, the QE/time axis framework kept monetary policy accommodative until the goal of positive inflation was reached.

“However, the exit from the QE/time axis monetary regime, in March-July 2006, was premature…

“Once the QE/time axis regime ended, in March 2006, the BoJ shifted towards an inflation outlook regime, with a 0-2% range, and a center at 1%. This mechanism seemed to commit the BoJ to a loose inflation target. In practice, as seen in the great deflation of 2009, there was no commitment from the BoJ that deviations below the target range would be met with extra monetary measures. The role of discretion increased and, in the end, deflation worsened.

“The issue, therefore, is not whether Japan is suffering deflation, but rather whether changes of the monetary policy regime can do anything about it. This is where the reverse correlation zone model comes in. With a higher ZIRP [Zero Interest Rate Policy] point (i.e., setting a level of inflation which Japan must exceed before the BoJ exits the zero rate policy), combined with sustained QE, fiscal policy and other stimuli to GDP would have a longer period to work. That is, shifting the ZIRP point rightward would extend the reverse correlation zone, and accelerate and lengthen the recovery.”

Bottom line:  It would appear the Bank of Japan needs to signal clearly to the market, according to Mr. Feldman’s analysis, that it will keep interest rates low, and provide more liquidity, for much longer than now believed. 

Now on to the interesting USDJPY versus exports to the US correlation…reason number 2 as to why we are likely in the early stages of yen weakness… [Chart not available in text format.]

The chart above shows that USDJPY has been following the Japanese export numbers pretty closely i.e. lower exports and lower USDJPY.  Thus, the theory is simple:  If the US economic recovery is underway, the US is likely to import more Japanese goods (assuming Toyota can get its car in order), therefore if the correlation in the above chart continues to hold, USDJPY moves higher i.e. weakens against the US dollar. 

That’s our basic yen story and we are sticking to it until we get stopped out.

Jack Crooks
Black Swan Capital


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