Sticking With Our Yen Short

Position: Short the Japanese yen (FXY); Long the Chinese yuan (CYB)

On Chinese yuan manipulation: “Frankly, they haven’t let the currency move very much so far… They know they’re just at the beginning of that process and I think we’d like to see them move more quickly.”

On Japanese yen intervention: “They’re working through some difficult problems… My view is they should be focusing like we are on how to make sure they’re reinforcing recovery in Japan and doing things that are going to help.”

Both statements we’re made just last week by the same person – U.S. Treasury Secretary Tim Geithner. While we could spend quite a few paragraphs highlighting the hypocrisy embedded in these contrasting stances, we’d rather tackle today’s Japanese FX market intervention from a more analytical standpoint.

For the first time since 2004, Japan intervened in the currency market in an attempt to stem an 11%+ gain since mid-May, which caused the yen to tumble ~3% - a large intra-day move for a currency of this size and liquidity. Until today, the yen hadn’t eclipsed 85 per dollar in almost two weeks.

Yesterday we added to our short FXY position in our Hedgeye Virtual Portfolio, reinforcing our conviction that Japanese policy makers will do what they’ve done for two decades – intervene in financial markets. Should the latest round of intervention prove unsuccessful in reversing the recent up-trend, we anticipate further intervention from here. Our confidence lies in both the economic fundamentals and the rhetoric put forth by Japanese politicians in the weeks leading up to today: 

  • Japan’s 2Q GDP rolled sequentially: +1.2% SAAR. vs. +4.98% in 1Q
  • Deflation intensified in July: (-0.9%) YoY vs. (-0.7%) in June
  • Japanese Industrial production fell in July after being revised down: (-0.2%) MoM vs. +0.3% prelim.
  • Export growth slowed in July: +23.5% YoY vs. +27.7% in June
  • 8/27: Japanese Prime Minister Naoto Kan: “We will take bold action if necessary and naturally that can include intervention… We have to use every option available as a strong yen is likely to have a severe impact on companies.”
  • 9/8: Japanese Finance Minister Yoshihiko Noda: “We will take bold action if necessary and naturally that can include intervention [in the FX market]… We have to use every option available as a strong yen is likely to have a severe impact on companies.”
  • Kan’s election victory over Ozawa was by a slim margin among Japanese legislators (+6 votes). This meant he would have to relinquish on the margin his relative fiscal hawkishness and conform to Ozawa’s “support the economy by any means necessary” approach if he is to maintain stability within the DPJ.
  • Today: Japanese Finance Minister Noda: “We will continue to watch developments in the market carefully and we will take bold actions including further intervention if necessary.” 

To be crystal clear, however, we aren’t short the yen purely based upon the catalyst provided by the current batch of Fiat Fools leading Japan. We think the top in the yen is around yesterday’s pre-intervention level of 82-83 per dollar and we see downside on a 3-6 month go-forward basis around 6-9%.

The reasons for our bearish stance are: the potential for both waning upward Chinese pressure on the yen and U.S. dollar stability.

We’ve been vocal in recent weeks highlighting the shift by China into short term JGBs an out of short term U.S. Treasuries. The most recent data for both confirm this trend: 

  • China bought more bonds than it sold in July for the seventh straight month: 583.1 billion yen vs. 457 billion yen in June – a sequential acceleration. Reports from Japanese banks suggest the incremental holdings to be comprised of mostly short term JGBs.
  • China’s holdings of short term Treasury bills fell further in June, giving the securities a 98% peak-to-trough decline within China’s FX reserves. 

Why would China seek to pump up the yen on such short notice? There are two reasons, one of which is linked directly to Tim Geithner’s comments mentioned above. By forcing Japan to intervene in the FX market, China can either hope that Japan’s intervention will alleviate pressure from U.S. Congress to expedite the appreciation of the yuan. Should the finger-pointing persist, China now has a stronger case for resistance, pointing out the U.S.’s aforementioned hypocritical stance on currency manipulation. As recently as today, China's Ministry of Commerce said that its trade policies shouldn't be dragged into U.S. electioneering and rejected criticism of the yuan's value as "groundless".After imposing duties on Chinese-made steel pipes Monday, the U.S. Department of Commerce is meeting today and tomorrow to discuss China’s currency policy. After Japan’s actions today, we don’t expect the findings of this meeting to provide any meaningful incremental pressure on the yuan.

Another reason China may want to allow the yen to appreciate is to alleviate competitive pressure as it slowly allows the yuan to appreciate to combat inflation – Chinese CPI accelerated in August: +3.5% YoY vs. +3.3% in July. Today, the yuan touched 6.733 per dollar, which is the strongest level since the central bank unified the official and market exchange rates in 1993. Further, it has strengthened 0.8% in the past five days alone.

As previously mentioned, a second tenet to our bearish view on the dollar is the potential for dollar stability based on fiscal restraint and foreign central bank dollar buying. According to our proprietary models (which were designed using the specific analytic insight of Karl Rove), we expect the Republicans to take control of the House and for them to win 49 or more seats in the Senate – more than currently estimated by consensus. We feel this marginal shift towards fiscal conservatism out of Congress post the midterm elections will provide much needed support for the U.S. dollar, which has lost ~8% of its value since its cycle peak on June 7.

To find evidence of accelerated foreign central bank dollar buying, one needs to look no further than Brazil – though there are certainly many other countries expressing similar concern. Brazil’s central bank held two daily auctions on three days last week to buy dollars, marking the first time since May that it opted for more than one round of purchases. This is on the heels of Brazilian Finance Minister Guido Mantega’s vow last week to not allow the real to continue appreciating. Korea and Malaysia are two more Asian nations (in addition to Japan) that are expressing concern over recent appreciation.

In short, we stand counter to consensus that the yen will continue it March upward. While a pullback to the 82-83 level is likely in the near term, the 3-6 month outlook for USDJPN is decidedly bearish.

Darius Dale

Analyst

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