Hedge funds worldwide have been counting on a rise and subsequent fall in USDJPY, and conditions remain intact for that to happen, though not to the extremes that many once expected.
Without Bank of Japan (BoJ) monetary easing, there would have been deflation of 2%, and this would imply, according to Keynesians, not only a liquidity trap where banks do not want to lend and firms cannot invest, but potentially a deflationary spiral.
Japanese exporters are in strong price competition with China and South Korea. An exchange rate of 100 to the dollar is already above the level of 90 that Japanese exporters wanted in 2010 and 2011, but the Japanese profit from low wage increases and higher technological standards compared to their counterparts from China and South Korea. We computed a fair USDJPY value of 95 (read why at SNBCHF.com).
If the weak yen persists, the supply chain of Japanese multinationals will be more and more insourced as opposed to relying on China and other (formerly) cheap countries that have for years experienced high wage increases. This creates jobs, and, helped by some higher inflation caused by the weaker yen, it also creates higher wages.
While the European and US crises are far from over, the Japanese balance sheet recession (i.e. people want to minimize debt, they do not want to spend, and firms do not want to borrow) had already finished in 2010. The Japanese have high savings, unlike many Americans, and they are able to spend with their own money, and as a result, they do not need deficit spending incited by the central bank.
The quadruple effect of higher spending, higher exports, more jobs, and fiscal spending will no doubt bring about inflation in Japan.
The USD/JPY 80-to-120 Move
This is reflected in the famous 80-120-100 trade in USDJPY that many hedge funds play. The US recovery and overshooting will move USDJPY to 120, and some think that the eventual exit from “Abenomics” will help the yen come back to 100.
Robert Savage of FX Concepts and Alan Ruskin of Deutsche Bank are opinion leaders in the current short yen trade. They are able to manipulate a lot of trading (quant) algorithms and influence FX traders. Some hedge funds, like those of Kyle Bass of Hayman Capital and Axel Merk of Merk Investments, even see Japanese government bond (JGB) yields exploding and continuing the weakening of the yen to 150 and more.
What many do not grasp is that the deflationary "tradition" and the Japanese-style technology will be able to counter imported inflationary effects. Despite an exchange rate of 100 or more, and a loss of 35% against the dollar and euro, inflation is still far. But the minus 2% deflation scenario has been avoided.
Thanks to higher competitiveness and still-low inflation, Japan should see the strongest real GDP growth of the G7 nations for Q2 and Q3 of 2013.
The USD/JPY 120-to-100 Move
Japan’s economy grew by 0.9% quarter-over-quarter (q/q) and the US by only 0.6% (annualized 2.4%) in Q1 of 2013. Each May, the US economy softens a bit while Japan becomes stronger. The growth gap between Japan and the US will be bigger, and we expect that Japan will expand by 0.5% more than the US in Q2.
The difference, however, shows that even the 80-120-100 trade might not be sustainable. This summer, the 120 should get out of reach and the yen could improve to 90 or 95 again.
A stronger yen will mean that inflation will be limited and JGB yields will fall again. A Kyle Bass scenario calling for a Japanese default might be exaggerated.
If, however, the US recovers, improves its competitiveness issues, reduces unemployment (which we doubt), and US inflation rises, then Japan could really go bust because it will need foreign investors to finance the debt that demand far higher yields.
As we have seen in the manufacturing ISM data, the US has been unable to create many jobs in manufacturing. Effectively, US manufacturing is weaker than ever.
In the end, most of what Americans spend will be beneficiary for countries with strong trade surpluses like China, Germany, and Switzerland. Japan is also increasing its trade surplus with the US, but is currently losing against China, Germany, and austerity-ridden Europeans.
In summary, the famous 80-120-100 trade in USDJPY will instead be an 80-104-90 trade.
I personally recommend long-term investors buy Japanese stocks, but denominated in yen. Be sure that you buy on dips. The SNB followed this strategy in Q1, visible in an increased yen and equities share, and it returned high profits.
By George Dorgan of SNBCHF.com
- Finance Trading
- Bank of Japan