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Takeaway: We continue to see risk that Japan experiences a currency crisis (peak-to-trough decline > 20%) over the intermediate term.

SUMMARY BULLETS:

  • Could the USD/JPY cross approach 100 or beyond? Most definitely, assuming a scenario in which most of our pending POLICY and PRICE catalysts materialize. As we outlined on our 11/15 firm-wide Best Ideas conference call, we think there is risk of Japan experiencing a currency crash (i.e. a peak-to-trough decline > 20%) over the intermediate term. For the record, a -20% decline in Japan’s currency from the 11/15 closing price of ¥81.17 on the USD/JPY cross puts the yen at ¥101.4625 per USD. That would be a sight to see, as the yen hasn’t traded sustainably above ¥100 per US dollar since 2008.
  • To detail the aforementioned POLICY and PRICE catalysts, we view each one of the following risks as probable over the next 12-18 months:
    • A +2-3% joint Diet-BOJ INFLATION target;
    • A stimulus package introduced by Prime Minster-elect Shinzo Abe;
    • A VAT hike delay;
    • The LDP wins a  majority in the Upper House pending elections in JUL or AUG;
    • An erosion of BOJ independence, with the BOJ governorship and two deputy governorships eventually assumed by LDP puppets;
    • Experimental monetary POLICY – particularly a foreign asset purchase program; and
    • The UST 2Y-JGB 2Y yield spread widens in any meaningful way.
  • As we explicitly stated in our 11/9 note titled, “THINKING THOUGH A POTENTIAL CURRENCY CRISIS IN JAPAN”, sustained yen depreciation and expectations for that to continue is bullish for Japanese equities until it isn’t (i.e. until the JGB market cracks in a material way). Despite the Nikkei 225 Index having appreciated +12.2% since then, our fear of a DEVALUATION and/or INFLATION-induced Japanese sovereign debt crisis will continue to keep us on the sidelines here. If you are, however, inclined to play our bearish bias on the yen via the Japanese equity market, we strongly caution against overstaying your respective welcomes. For a deeper discussion of the drivers behind such a move in the JGB market, please refer to our 7/27 note titled: “ARE JAPANESE GOVERNMENT BONDS POISED TO MAKE SOME NOISE?”.
  • One key risk to consider at the current juncture is the fact that our call has become somewhat consensus, though we counter that there is room for the market to get a lot more bearish here and that the market’s commercial players are still ragingly bullish on the yen to the tune of +3.5x standard deviations relative to the trailing 52-week average. Moreover, investors would be highly remiss to forget the #1 reason why there exists a political will to devalue the yen in the first place – Japan’s secular erosion of competitiveness. We are making an explicit call that POLICY, not sentiment/positioning will increasingly drive the boat here, leaving behind a much lower JPY in the process.

Over the weekend, we received confirming data to support our bearish intermediate-term bias on the Japanese yen – specifically in that the Liberal Democratic Party of Japan (LDP) is projected to capture 296 seats in the 480 seat Lower House of Japan’s parliament (Diet). Combining with the New Komeito Party’s (NKP) projected 32 seats, Japan’s new ruling coalition has garnered an omnipotent two-thirds majority needed to overturn any bills that are rejected in the Upper House, which is still controlled by the DPJ (elections likely in JUL or AUG ’13).

The two-thirds majority will allow LDP president and Prime Minster-elect Shinzo Abe to push forth with his reflationary campaign unabated. Per the LDP’s recently-released manifesto, he plans to pursue nominal GDP GROWTH of +3% by:

  1. Setting a joint INFLATION target with the BOJ of +2-3 and having the BOJ pursue “unlimited easing” until the target is sustainably reached;
  2. Implementing economic stimulus via a “large-scale” extra budget; and
  3. Delaying the 2014 VAT tax hike if necessary.

In addition to these steps, Abe has also supported altering Japan’s pacifist constitution to increase defense spending and the number of military personnel in order to enforce a harder stance towards China with regards to the Senkaku/Diaoyu Islands dispute. As we called out in our 9/27 note titled: “IDEA ALERT: SHORTING THE YEN AS SINO-JAPANESE TENSIONS ESCALATE”, any foreign POLICY maneuvers that exacerbate Sino-Japanese tensions will equate to lower Japanese GROWTH (China is far and away Japan’s largest export market at 19.7% of shipments). That will ultimately force Japanese policymakers to do more of steps #1-3 to shore up the Japanese economy.

FYI, Japan is currently mired in its 2nd recession in as many years (third in the last four), so Abe & Co. definitely have a lot of “shoring up” to do with regards to the Japanese economy. Our bearish thesis on the Japanese yen is deeply simple: the more they do, the steeper the JPY is likely to fall vs. the USD – especially in a Global Macro environment where US monetary POLICY isn’t getting incrementally dovish and US fiscal POLICY is poised to get directionally hawkish.

 

BEST IDEAS UPDATE: IS THE USD/JPY CROSS GOING TO 100? - 1

 

BEST IDEAS UPDATE: IS THE USD/JPY CROSS GOING TO 100? - 2

Could the USD/JPY cross approach 100 or beyond? Most definitely, assuming a scenario in which most of our pending POLICY and PRICE catalysts materialize (more on the latter later). As we outlined on our 11/15 firm-wide Best Ideas conference call, we think there is risk of Japan experiencing a currency crash (i.e. a peak-to-trough decline > 20%) over the intermediate term. For the record, a -20% decline in Japan’s currency from the 11/15 closing price of ¥81.17 on the USD/JPY cross puts the yen at ¥101.4625 per USD. That would be a sight to see, as the yen hasn’t traded sustainably above ¥100 per US dollar since 2008.

BEST IDEAS UPDATE: IS THE USD/JPY CROSS GOING TO 100? - 3

Make no mistake, Japan is likely at the cusp of experiencing a major delta in monetary POLICY – not dissimilar in magnitude to what the US experienced under the transition from Arthur Burns to Paul Volcker. Only this time, Japan is doubling down on its largely-failed Keynesian POLICY experiments, whereas the US took that opportunity to rightfully stifle the center-left leanings across its monetary POLICY landscape.

Jumping back to the aforementioned PRICE catalyst, we see heightening risk that the US sovereign debt market starts to make lower-highs over the intermediate term, as the yield on the 10Y UST has broken out above our 1.69% TREND line. If prices on the long end of the Treasury curve in any way start to leads the short end lower, we could see a potential widening of the UST 2Y-JGB 2Y yield spread – much to the detriment of the Japanese yen. If our Macro team is right on the US consumer (via Bubble #3 popping) and Josh Steiner is appropriately the bull on US housing, there’s little reason to believe the bond market won’t front-run any marginal changes in US monetary POLICY.

BEST IDEAS UPDATE: IS THE USD/JPY CROSS GOING TO 100? - 4

One key risk to consider at the current juncture is the fact that our call has become somewhat consensus. When we introduced our bearish TREND and TAIL bias on the JPY on 9/27, the speculators in the futures and options market were net long the yen to the tune of 21.9k contracts. Now they are over two standard deviations net short (on a trailing 52-week basis) per the latest reported data (-95.1k contracts). While sentiment/positioning do score positive for the yen from a short-term perspective, we counter that there is room for the market to get a lot more bearish here (-191.4k contracts in 2007) and that the market’s commercial players are still ragingly bullish on the yen to the tune of +3.5x standard deviations relative to the trailing 52-week average.

BEST IDEAS UPDATE: IS THE USD/JPY CROSS GOING TO 100? - 5

 

BEST IDEAS UPDATE: IS THE USD/JPY CROSS GOING TO 100? - 6

Not to mention, investors would be highly remiss to forget the #1 reason why there exists a political will to devalue the yen in the first place – Japan’s secular erosion of competitiveness. We are making an explicit call that POLICY, not sentiment/positioning will increasingly drive the boat here, leaving behind a much lower JPY in the process. It would be a gross understatement to suggest Abe is sick and tired of the Shirakawa-led BOJ consistently losing battles to Ben Bernanke amid the global “Currency War”.

BEST IDEAS UPDATE: IS THE USD/JPY CROSS GOING TO 100? - 7

All told, we continue to see risk that Japan experiences a currency crisis (peak-to-trough decline > 20%) over the intermediate term. That’s a critical Global Macro risk to manage accordingly – irrespective of your primary asset class focus. For example, anyone long domestic exporters with outsized exposure to Japan from a currency translation risk perspective would be best served stress-testing their models for meaningful USD strength over the intermediate term. Email us if you’d like to arrange a deeper discussion of our call and the implications therein.

Darius Dale

Senior Analyst