Conclusion: The Japanese government is under pressure to artificially weaken the yen. Regardless of any potential action that may be taken, it is not likely going to be enough to prevent growth from slowing on the island economy.
Position: Short the Japanese yen (FXY).
Japan’s exports slowed sequentially for the fifth consecutive month in July, furthering concerns that the Japanese central bank will intervene in the currency market to stem the yen’s recent rise to a 15-year high against the dollar and a nine year high vs. the Euro. Exports came in at +23.5% Y/Y vs. a 27.7% increase in June and the data looks to continue to weaken from here in the face of the yen’s 12% advance vs. the U.S. dollar since its April 5th cycle low.
Of course this is absent any intervention by the Bank of Japan in the currency market, a tool that has not been used by Japanese policy makers since March of 2004 when they sold 14.8 trillion yen in 1Q10 after record sales of 20.4 trillion yen in 2003. The gloomy backdrop for global growth and waning final demand from Western consumers suggest 3Q10 to be potentially as ominous from a decision-making standpoint and both the Japanese and American bond markets have been signaling slowing growth for months.
Just today, Japan sold 4.8 trillion ($57 billion) of three month treasury bills at the lowest yield (0.1123) since the Bank of Japan ended its QE policy over four years ago (April 26, 2006), which indicates investors are likely speculating that Japan will ease its monetary policy to stem the recent gains in the yen. Japanese Finance Minster Yoshihiko's recent change in tone supports such speculation, saying today, “We have to take appropriate action when necessary, though I plan to continue to watch currency movements very closely with great interest.”
This statement follows similar commentary out of Japan’s Trade Minister Masayuki Naoshima, who said Friday, “The yen is too strong against the dollar and should weaken about 6% to help the country’s exporters.” Officially, the government has not yet outlined a response to the yen’s surge, though last week Prime Minister Naoto Kan ordered his ministers to submit plans for additional economic stimulus (how shocking). The Nikkei Newspaper reported today that the Bank of Japan’s funding program which provides funds to lenders at 0.1% may be expanded to 30 trillion yen ($356 billion) from 20 trillion and the duration of loans may be increased to six months from the current three. To date, Kan has been tight lipped on government intervention in the currency market, though that could change by the next Bank of Japan meeting, which is scheduled for September 6-7.
All told, we continue to be bearish on Japan’s economic health for the long term as a result of unfavorable demographics (ageing population), burgeoning sovereign debt (way past the Rubicon of 90% Debt/GDP), and trade exposure to a deleveraging, jobless U.S. consumer (~16.5% of exports). Regarding that exposure, Toyota, the world’s largest carmaker, has said every one-yen gain against the U.S. dollar reduces their annual operating profit by 30 billion yen. Sony, which generates over 70% of its sales outside of Japan, echoes similar sentiment, claiming it loses about 2 billion yen of annual operating profit for each one-yen gain vs. the dollar.
Company commentary like this is particularly valuable as it relates to timing central bank action. According to the central bank’s Tankan survey released July 1st, Japan’s large manufacturers expect the yen to average 90.16 per U.S. dollar in the fiscal year ending March 2011. Currently, the average is slightly stronger for the fiscal year-to-date, averaging 90.06 per USD. With the negative barrage of economic data we are likely to receive from the U.S. and W. Europe in the next 6-9 months, the yen will have further upward pressure as investors flock to “safety” globally (we disagree that holding a bag full of yen is safe, but that is the subject of another debate).
It appears that Japanese policy makers will be under increasing pressure to artificially weaken the yen or risk economic stagnation and rising unemployment from declining export competitiveness in the face of what is already slowing consumer demand from western economies. Regardless of any potential action that may be taken by Japan’s central bank, it is not likely going to be enough to prevent growth from slowing on the island economy. The Japanese equity market agrees with our assessment on both a short term and longer term duration, down 22% from its YTD peak on April 5th and down 77% since its January 1990 peak. Ironically, April 5th is the same day the yen put in its YTD low vs. the U.S. dollar. In the end, the deep simplicity that is Chaos Theory always wins in the land of Macro investing.
Simple is as simple does, at least according to Ichiro Ozawa (the former No. 2 official in the ruling Democratic Party of Japan) when referring to his American counterparts. For the sake of U.S. equities, let’s hope the Fed keeps it simple and avoids getting too cute with stimulus going forward, or else stocks in the U.S. will continue to be “cheap vs. bonds” for the foreseeable future.
Hope, however, is not an investment process.