Shorting Tail Risk: EWJ Trade Update

Current Virtual Portfolio Positioning: Short Japanese equities (EWJ).

Earlier today, Keith re-shorted Japanese equities via the iShares MSCI Japan Index Fund (EWJ) in our Virtual Portfolio. The Nikkei 225, which is up +2.6% week-to-date, is being propelled to the upside largely on the strength of FX translation relief (the yen is down -1.6% against the USD in the-week-to-date vs. a regional median of -0.3%).

To be clear, we think consensus risks going back to the well one-too-many times on this one, as the sequential ramp in sovereign debt maturities in MAR (¥57.1T or $725B or 5.8% of total marketable JGBs) provides a potential starting point for a Japanese sovereign debt issues. Broken from our long-term TAIL perspective (despite the YTD beta-rally across global equity markets), the Nikkei 225 index is signaling to us that there is at least some degree of tail risk that we must appropriately explore.

Shorting Tail Risk: EWJ Trade Update - 1

To be even clearer, we are not calling for a Japanese sovereign debt crisis in MAR. Rather, our analysis of the drivers within the JGB and JPY markets suggest that a number of key tailwinds have inflected/look to inflect in 2012. Coupled with an all-time high amount of JGB issuance that needs to come to market throughout this calendar year, we think the tea leaves suggest being appropriately hedged against what may be the next stop in our Sovereign Debt Dichotomy theme (originally published in 2Q10).

One of those tea leaves is the yen’s underperformance in the YTD (down -2.6% against the USD vs. a regional median of +2.5%). While much of the yen’s underperformance has been fueled by decreased risk aversion, which manifests itself via higher U.S. rate expectations on a relative basis (as measured by the spread between U.S. and Japanese 2yr OIS swaps), we don’t view a -500bps negative divergence as something to shrug off ahead of increased stress in the Japanese sovereign debt market. Should the risks we are flagging materialize, we ultimately think this trade plays out in the currency market via yen weakness vs. the USD.

Shorting Tail Risk: EWJ Trade Update - 2

Email us is you’d like to dialogue further on this growing topic.

Darius Dale

Senior Analyst