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Summary investment conclusion

We are negative on the yen from a quantitative perspective with current Yen trade convictions include a sell TRADE level of 101.75 and a Sell TREND level of 106.88 with no anticipated support above 98.21.

From a fundamental perspective, Japan policy makers, as we outline below, really have no choice but to aggressively implement a weak Yen policy.

Overview

Media reports this morning predicted that the third stimulus program, which will be unveiled on Friday by Prime Minister Taro Aso, will total more than 15.4 trillion Yen as Aso and his LDP colleagues respond to the continuing downward slide in the Japanese economy and their plummeting approval ratings. With September elections looming, the public reception of the stimulus will be critical as it moves to the opposition controlled upper house for approval (it took nearly four months to pass the previous plan). The Japanese politicians face a problem common to their counterparts across the globe, not implementing a large enough stimulus package, fast enough to arrest a substantial economic contraction driven by concurrent external and internal factors of a magnitude not seen since the Great Depression.

Recent Background: Equities & the Yen

The relationship between the Yen and Japanese equities is uniquely interdependent due to the overlapping importance of export industries and the heavily concentrated equity exposure of the Japanese banking system. As such, the relationship is a two way street, with the yen showing a greater sensitivity to domestic equity market valuation than any other major economy’s currency.

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In January Finance Minister Kaoru Yosano announced that the government would inject liquidity into three regional banks to the tune of 121 billion ¥ and the option of direct purchases in the equity markets to arrest the fall in the Nikkei 225, which had tumbled to a 26 year low. This announcement came on the heels of  a proposed 100 billion ¥ preferred share purchase in three banks announced in December as part of a program to inject as much as 12 trillion ¥ into domestic banks in an effort to provide liquidity to the banks with the objective that they will extend credit to prevent corporate bankruptcies. In The wake of these announcement the equity markets continues to slide in the face of strengthening Yen.

It was only the initial announcement of the third stimulus program in March, combined with an increase in the BOJ program of Purchasing Treasury bonds, which reversed the equity markets slide. Since the second week of March the Nikkei had rebounded by more than 25% and the yen simultaneously weakened as this “shadow quantitative easing” helped inspire greater confidence in future export prospects and asset allocation eased upwards pressure on the Currency in turn.

Conclusion: Only One Path Out

The new stimulus program is heavily weighted towards inducements for increased domestic consumption. The prospects of reversing the savings trend and inducing the consumers back into market in the face of rising unemployment do not look promising. The Economic and Social Research Institute’s (ERSI) consumer confidence index continued its modest upward trend in February, rising to 26.7, incrementally higher than January’s 26.4 index but still hovering near the survey’s lowest reading on record, of 26.2 in December. Surveyed households, asked to provide their outlook, six months forward, of the four categories in the survey; overall livelihood, income growth, employment, and willingness to buy durable goods, registered levels showing that perceptions of income growth and employment continued to decrease for the month. With registered auto sales declining 32.4% Y/Y for March, the stimulus plan provisions for hybrid rebates seems particularly anemic –with prospects of making up the difference in domestic sales unlikely, let alone the drop off in external demand.

Prospects for the other major source of Japanese economic activity, exports, continue to look grim in the face of decimated North American and European demand. On an absolute Yen basis February exports, while a marginal improvement over January, still registered at levels lower than any pre 2009 figures since August 1996. Industrial production contracted by 37.66% Y/Y in February following months of extreme contraction in output as well as shipments and capacity utilization.

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The the modest uptick in machinery orders for February reported by the cabinet office today: up 1.37% M/M and -30.21% Y/Y ( a sequential improvement over January), seem to be an unconvincing sign of a bottom in production prior to confirmation by March export data.

Even is the stimulus program to be announced on Friday does accomplish increased in internal conumption, the heavy weighting towrads tax incentives and other government reveues rather than direct monetary injectiosn leaves a strong perception that the cupboard, at last, is bare. Japanese government leaders are now operating with the fact that any ability to implement more fiscal stimulus is restricted by a debt burden now estimated by the OECD at approximately 197.3% of GDP for 2010. A large and growing fiscal deficit, coupled with large sovereign debt obligations and credit agencies reeling from the ongoing perception of their ineptness, leaves us with the conclusion that the impact of increases debt levels going forward on Japan’s sovereign credit rating must be .

Taking all of this into account, the only logical policy left open to the Japanese government appears to be the pursuit of a weaker Yen despite all negative consequences.

Levels

As tactical investors, we balance our fundamental view with a quantitaive approach to near term market positions. Our current Yen trade convictions include a sell TRADE level of 101.75 and a Sell TREND level of 106.88 with no anticpated support above 98.21.

Andrew Barber
Director

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