- Japan's longer term interest rates have spiked too quickly
- The recent Yen strength has to be seen corrective in nature
- The Japanese government will put in place clear policy directives with which further sharp interest rate moves will be prevented
- We have reduced our Yen short positions substantially over the last two weeks and have locked in a substantial profit and have freed up 'fire power' for re-entering this trade once we are confident that the above conditions have been fulfilled
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Long time readers and our investors will know that we have been involved in the short yen trade since November 2012 and that it has been a very profitable position. We have, however, substantially reduced our Japanese yen exposure over the last weeks, down to a minimum amount, with which we wait for this correction to be over. We, here at Archrbridge, believe this to be a correction and not the end of yen weakening.Below we describe why we have substantially reduced our positions and why we believe in the inevitable re-ignition of this trade once further policy steps by the Abe administration have been taken or more cooperation between the government and bondholders has been established.
Without entering the debate about Japan's ageing population, its lowered savings rate and its negative trade balance as we have discussed in older issues ("I think I am turning Japanese" November 25, 2012), we point out that in essence Japan has no choice but to devalue its currency in order to be able to grow its economy via exports which then in turn would translate into an increased demand for labour and push up wages. This should, in turn, entice further spending and aid the overall economic recovery and push Japan out of deflation which has been plaguing it for the last 15 years.
This aim of weakening the currency needs to, however, be achieved without raising the longer term bond rates due to the large debt and lack of revenues the government has. Tax revenues have been diminishing for decades due to the deflation and low growth the country experienced. Combined with the large debt stock, means that currently the Japanese government pays around 25% of its revenues on debt servicing costs (i.e. the interest rate of the debt they have). If rates were to rise from its current 0.8% to above 2% then around 80% of revenues would be spent on paying the interest rate of the current debt stock (not counting additional debt building up till then). This would become unsustainable if rate rises were to occur before nominal GDP picks up. (Graph: Grant Williams)
Once we understand that the government needs to devalue its currency without raising longer term interest rates we can determine that in order to do so requires a vast amount of QE (which the government is doing), while convincing bond holders to remain bond holders. Currently, we are witnessing that large pension funds and other bond holders are increasingly selling their stock of bonds in order to either invest in the equity markets or to invest in non-yen holdings. Since more than 85% of bond holdings are in Japanese hands it seems reasonable to assume that some sort of agreement can be forged between the government and bond holders that would prevent violent moves in bond yields. This can take many forms and will have to satisfy bond holders enough not to sell their holdings just yet, even if they believe in the eventual success of 'Abenomics' and with it inflation. We are hopeful that this issue will be resolved, even if this should mean that the BOJ will have to give guarantees to buy all of the bonds issued for any given year. We believe this, because Japan has no other cards to play.
Once this has been accomplished we will see a resumption of yen weakening. Please note that this will have to be a consistent weakening over a number of years with approximately 15-20% per annum of yen weakening in order to achieve the targeted 2% inflation within a few years. This would mean that the yen would require to achieve higher levels than the 120 $/Yen it saw in 2007.
We are as always doubtful if permanently higher inflation rates can be engineered in this way, since that would require an ongoing weakening of the currency for the foreseeable future, but we are certain that the currency will be allowed to weaken over time, once the above discussed policy moves have been agreed. This is the reason why we see this move from 103 to 100 as a 'correction' but have erred on the side of caution and have substantially reduced our position a while ago when we saw interest rates spiking from around 30bps to above 80bps.
Disclaimer: This posting is for information purposes only and is not intended as an offer,recommendation or solicitation to buy or sell, nor is it an official confirmation of terms. No representation or warranty is made that this information is complete or accurate. Any views or opinions expressed do not necessarily represent those of Archbridge Capital AG. This information is not intended, tax or legal advice. You also acknowledge that the information should not be construed as a solicitation or offer by Archbridge Capital AG to buy or sell any securities or any other financial instruments or provide any investment advice or service. Unless otherwise stated, any pricing information given in this posting is indicative only, is subject to changes and does not constitute an offer to deal at any price quoted. You should be aware that returns can be volatile and you may lose all or a portion of your investment. Past performance of any investment or trading tool is not necessarily indicative of future performance or results.