Fundamental Forecast for Yen:Neutral
- The Yen put in its largest annual loss after the Bank of Japan made a surprise move to negative rates.
- USD/JPY: Shock and Some Awe (critical resistance zone in 121.50-122 area).
- USD/JPY – Don’t Forget About the 26-Year Trendline.
- Track changes in positioning and sentiment in real-time to filter trends and opportunistic trade ideas.
Confidence is a pretty important thing in a financial system. After all, in a fiat-based monetary system, all that we really have is faith. There’s no gold or silver backing the currency, and while I’m not saying that’s a ‘good’ thing since pretty much all of those regimes have failed, faith is of utter importance because, should trust wane investors may just sell out of your currency at an uncontrollable pace. This could lead to significant currency weakness as investors flock to anywhere but your currency, and all of those goods that you have to import all of the sudden begin to get very, very expensive. This is one of the reasons that negative rate-regimes have been avoided for so long: It could be potentially playing with fire (the inflationary kind). And this inflation isn’t of the ‘healthy’ variety. Just ask Russia. This even began to show signs in Canada earlier this week with reports of the Great Cauliflower Crisis; where four simple heads of Cauliflower could buy a full barrel of Oil. But this isn’t about cauliflower; we’re talking about history here.
The Bank of Japan shocked pretty much everybody watching last night by pulling rates into negative territory. I’m not aware of anyone that saw this coming or even thought of it as being a possibility. As a matter of fact, until a leak hit news wires in Japan just ahead of the announcement, the prospect of negative rates had been seemingly eliminated by the man at the top of the BoJ himself, Mr. Haruhiko Kuroda, just two weeks ago. Just before flying to the World Economic Forum in Davos, Mr. Kuroda told Japan’s parliament that he wasn’t even considering negative rates. And this made sense: Even at the lows of this thus far painful year, as panic was at an apex, the Yen was still 54% weaker against the US Dollar compared to the pre-Abe highs. And while Japan was still far from ‘turning the corner’ on the inflation front, the case could be made that they were in a significantly more handsome position than many other economies in the world.
But Japan saw this as a big threat apparently. After ‘Abe-nomics’ really only provided relief in the form of exchange rates, growing risk aversion around the world exposed the Yen as a prime candidate for safe-haven flows. As investors ran out of riskier investments and riskier currencies, the seeming safety of a developed Japan could be a really attractive draw, even if rates were next to zero. In panics, the onus is on return OF capital, not return on capital. But that was effectively nullified last night by Japan’s move to sub-zero rates. Now staying long Yen actually costs money. Being short Yen pays (theoretically), and further to the point, there are quite a few more reasons for Japanese businesses to employ that stored capital. So, by design, negative rates could help; it’s just that we don’t have any evidence that they actually do. The only case study of a major economy going negative is Europe and, well; let’s just say that shouldn’t serve as a positive example of anything yet. Outside of that we have Denmark’s example of going negative, but that’s not really a relevant comparison considering the disparity in sizes between the two economies.
So, this is a gigantic experiment that could potentially have very, very ugly consequences. There is no compelling reason to be long of the Yen until something significant changes. Safe-haven flows should be directed elsewhere, as the threat of even deeper-negative rates could create additional drag on risk-aversion flows. Mr. Kuroda warned last night, he will go more negative if he has to.
But there’s another factor here; because economies don’t exist in vacuums. China is in a fairly precarious state at the moment. China and the US are basically tied for the top export destinations for Japan ($133B and $134B respectively), and this move by the BoJ just put pressure directly on both of those trade partners. Now Japanese products are going to be more attractive in these economies, and their respective products (Chinese and American) will be less attractive in Japan. This is not going to help China, and this may serve as just another crimp on growth in an already vulnerable American economy as flows move from Japan to the US. This may even be the type of provocative move that could create ire in Chinese media sources and throughout the Chinese economy.
The problem in China is debt, and frankly they need a weaker currency to help boost exports so that they can a) continue servicing debt b) continue to grow at a pace that will allow that 280% debt-to-gdp ratio to come down to a more palatable level over the next 10-20 years and c) continue growing a middle class so that the country can decrease its brutal reliance on exports because, as Japan just showed us, being an export-based and driven economy just makes you vulnerable to global trade winds.
As the Yuan strengthens, that makes all of this just that much more difficult, and with Japan now going negative on deposits, that just drives more trade flows into the Yuan. And a stronger Yuan is pretty much bad for the entire world right now as Chinese products get more expensive internationally, and less comes back to China in the form of Yuan. For China, the timing of this move couldn’t be worse. Fully expect China to respond, in some way. Chinese media was noticeably quiet last night, and this is normal in such situations as the state still controls (and authorizes) what the media can say about such matters. But we’ll have a report on that this Monday that should include some interesting weekend reading from Chinese-language sources.
For now – avoid long Yen. And even short Yen may be daunting considering that we’re just waiting on a response from China. But this may be a relevant option to mesh up with any currencies that you might actually want to buy. There isn’t much out there in that department not named the US Dollar right now, given that most major economies are already at or near-zero rates and expecting to stay there for a while.
This event is still far too fresh to move our forecast into bearish territory. We need to see more than one day of continuation before saying that this is a long-lasting theme.
One interesting idea should Yen weakness prove that it can hold could be a fairly flexible carry trade: Short Yen/Long Stocks. This was somewhat of the motive for that massive EUR/USD move last year after Europe went negative. Sell Euros for Dollars and then use those dollars to buy US stocks. This is what sent the S&P to its all-time-high and the strategy was fairly widely-followed but began to get nullified as Greek worries piped up again last spring, and the risk of a Euro break-up made that carry trade not-all-that-attractive any longer. There are a lot of ‘ifs’ to the potential execution of such a strategy in the current environment, and that’s somewhat indicative of the issue that we’re talking about. IF stocks continue to show the same strength as the past two weeks and IF China’s pain moderates, we could see risk aversion wane and that could make for an accommodating environment for the carry. Until then, there is a ton of risk and a lot of unknowns.
Until then, be careful of being long of the Yen. It is now a costly endeavor.