Back in July I drew reader’s attention to an assortment of factors that are potentially very bearish for the Japanese yen. These factors remain in place and if my assessment of them is correct, then the decline of the Japanese yen could be one of the most profitable trades of the decade.
In June 2007 the Japanese yen began a sustained rise and by October 2011 it had risen by 39% versus the US dollar. It also rose considerably against many other world currencies, notably the New Zealand dollar and Australian dollar.
As the chart below shows the yen rose against the greenback for more than four years, establishing a powerful trend channel. However in February of this year the Japanese currency broke decisively out of this channel, and since then it has been trending sideways.
A weekly chart of the USD/JPY
Chart courtesy of fxstreet.com
The unwinding of the yen carry trade
The primary factor that contributed to the Yen’s rise was the unwinding of the yen carry trade, and that has now come to an end.
A carry trade is a strategy in which an investor borrows money in a country with a low interest rate and uses the money to invest in assets in a country yielding a higher rate. The investor then attempts to capture the difference between the two rates, which can be substantial, depending on the amount of leverage used.
This investment strategy was used extensively between 1998 and 2007 to borrow money in Japan and invest in countries with much higher yields, such as Australia, New Zealand, the BRIC countries, and the United States.
In an attempt to spur economic growth, Japan lowered its interest rates close to zero making it profitable to borrow Japanese yen and invest in resource rich emerging markets, and activities such as subprime lending in the US.
The trade proved so lucrative that by early 2007 it was estimated that as much as $1 trillion may have been staked on the yen carry trade.
However, thanks to the arrival of the global financial crisis in the summer of 2007, these risky, leveraged bets, started to be unwound, marking the beginning of the end of the yen carry trade. The unwinding of hundreds of millions of dollars worth of investments created tremendous demand for Japanese yen, since in order to repay the low-interest loans, foreign currencies first had to be converted into yen. This caused the Japanese currency to rise considerably against other world currencies.
It now looks as though the unwinding process has come to an end and with it the support for the Japanese currency.
The end of the unwinding of the yen carry trade is no the only reason that the trend change on the chart above is potentially highly significant. There are a host of other factors that are bearish for the Japanese currency.
Factors that are bearish for the Japanese yen
As we have pointed out before, on aggregate Japan is now the most indebted nation in the world, and according to the IMF’s latest forecast their situation will get considerably worse over the next four years.
Total debt of the ten largest developed economies
Source: McKinsey Global Institute (MGI)
Note: Includes all loans and fixed-income securities of households, corporations, financial institutions, and government.
In May of this year the unsustainable nature of Japan’s debt caused Fitch to cut its rating to A+ from AA and further downgrades are more than likely.
It’s not merely the size of Japan’s debt that poses a serious threat; it’s also the average maturity. Japan has $11.3 trillion in outstanding sovereign debt (over 990 trillion yen), the majority of which matures in the next 2.5 years. That means that by the end of 2015 Japan will have to find buyers for a total of $5.75 trillion in maturing debt. That’s in addition to around $1.4 trillion that it must borrow to cover its budget deficit over that period.
Japan is also suffering from demographic pressures with its Baby Boomers beginning to retire and draw down on their pension funds, rather than paying into them. As a result Japan’s Government Pension Investment Fund (GPIF) – the largest pension fund in the world – has been forced to begin selling Japanese government bonds (JGBs). This is a major issue since the GPIF owns almost 12% of all outstanding Japanese debt and it now looks as though it will be a net seller.
The precarious nature of Japan’s fiscal position makes it all the more likely that the nation will soon run in to funding difficulties. At which point they will have to choose between austerity (and economic contraction), or money printing. However the latter seems much more likely.
Why more monetary easing is on the cards for Japan
Earlier today the Bank of Japan’s policy board voted unanimously to leave the target of its financial asset-buying program at 80 trillion yen after raising it from 70 trillion about two weeks ago. The board also decided to leave its overnight interest rate at 0 to 0.1%, where it has been since October 2010.
The BoJ also downgraded its economic assessment for the second month in a row, saying that, “Japan’s economic activity is levelling off”, while last month the bank said, “the pick-up in economic activity has come to a pause.”
Both Morgan Stanley and Credit Suisse are forecasting that Japan’s economy will contract in both Q3 and Q4 this year.
Speaking back in July, Deputy Governor of the BoJ, Hirohide Yamaguchi, said “When the outlook turns out to be weaker than expected or the risk associated with it intensifies, the bank will not hesitate to implement additional monetary easing.”
The latest forecasts indicate that inflation in Japan will stay below the BoJ’s 1% target for the next two years, and it’s becoming increasingly clear that the central bank is prepared to try new ways to try to end more than a decade of deflation.
Takahide Kiuchi, a former Nomura Securities economist who was appointed to the BoJ policy board in July said recently that after almost two years “of monetary easing centered on asset purchases, the time is coming to examine the impacts of the policies”. Mr Kiuchi continued, “If we conclude that the chance of achieving our target isn’t so high by extending the current policies, I think we of course need to consider new forms of monetary easing in a flexible manner.”
It is clear that the pressure is mounting on BOJ Governor, Masaaki Shirakawa, to provide more help for the ailing economy and many are now forecasting an expansion of its asset purchase programme at its next meeting which is on 30 October.
Japan is faced with an enormous debt burden, slowing economic growth (both globally and domestically), and the demographic pressures of an ageing population. And whether it chooses austerity or further monetary stimulus, the outlook for the Japanese yen looks distinctly negative.
It is my opinion that Japan will choose to inflate away a good portion of its debt. I therefore expect the BoJ to pursue ever more aggressive stimulus measures which will debase the value of the Japanese yen sending it into a long downtrend.
How to play the coming decline of the yen
There are several different ways to capitalise on a weaker yen. Longer-term investors might want to consider owning a selection of Japanese exporting companies that stand to benefit from a lower yen. Some names to consider include car companies such as Toyota, Mitsubishi and Nissan, as well as electronics manufactures like Canon, Panasonic, Sony and Nintendo.
These companies are likely to see greater demand for their products thanks to the greater relative purchasing power of foreign buyers. In fact, some of these companies are already beginning to raise their profit forecasts.
Those with trading expertise might consider shoring the yen against the US dollar in the futures market.
Dennis Gartman, publisher of the Gartman Letter, is also bearish on the Japanese currency. Back in March of this year he stated that, “the yen is doomed fundamentally. Japan just has so many problems, none of which are going to go away anytime soon.” Mr. Gartman has been shorting the yen on the currency markets and has placed trades that effectively allow him to buy gold and agricultural commodities in yen terms. If the yen falls and the price of these other assets rise, then he ought to do very well indeed.
It will take quite a lot of skill to profit from it, but in my assessment the decline of the Japanese yen could be one of the most profitable trades of the decade.