Yen again

"Just when I thought that I was out they pull me back in. "
-Michael Corleone, Godfather Part III

Macro Man was hoping to write about something else today, but cannot seem to escape the yen just yet. Today's FT carried an editorial urging the Bank of Japan to sell some of its foreign xchange reserves and buy yen. To do so, the piece claimed, would "boost the yen and its economy at the same time."

Three points:

1) This is a perfect example of the sort of fluffy argument that Macro Man alluded to on Monday. To claim that Japan has a large trade surplus so the yen must strengthen is lazy thinking, to put it politely. As Macro Man demonstrated on Monday, the trade surplus is actually smaller than the long run average, despite a confluence of surplus-boosting factors. As such, arguing that the yen is too weak on the basis of trade is fairly limp.

2) The author of the article claims that the reserves are "dead money" that the BOJ could better employ elsewhere. Wrong and wrong. The vast, vast majority of the reserves are owned by the MOF, not the BOJ, and the income generated by reserves goes onto the government's budget as receipts.

3) The author makes no attempt to justify how and why buying yen in the foreign exchange market would "boost" Japan's economy. Given that this is probably a necessary condition for the MOF to sanction intervention, the silence in terms of justification for the statement is deafening.

To be clear, Macro Man thinks that EUR/JPY is way, way overvalued. But that is a euro thing, not a yen thing. There are valid arguments to be made that this overvaluation should be corrected, and appropriate mechanisms for doing so. This limp editorial provided neither.

More interestingly, a poster drew Macro Man's attention to a phenomenon of which he was admittedly ignorant. Apparently, there is a semi-widespread belief that last spring's decline in USD/JPY from 118 to 109 represented some sort of massive carry unwind that eventually filtered through into other assets, eventually dragging global equities lower.

Certainly, a glance at the chart of USD/JPY and the SPX, for example, clearly indicates that USD/JPY went down and then some time later, the SPX went down.

It is is factually true that USD/JPY went down, and then so did the stock market. However, one of the first things that Macro Man learned as a callow young trader is that "correlation does not imply causality." That is certainly the case here.

In the few weeks of 2006, macro and currency traders were indeed involved in the carry trade generally and long dollars specifically. However, the downgrade of Iceland in February 2002 and subsequent attention on external imbalances led to more selective position-taking. Contrary to what appears to be the popular image of macro/currency traders as yield-obsessed coupon clippers, there are plenty of times when nominal interest rates are not a particularly strong driver of positioning.

Starting with the Iceland downgrade, currency traders began to focus on external imbalances as a driver of currency moves. Cue sharp declines in most currencies sporting large current account deficits, such as the ISK, TRY, NZD, HUF, and USD.

By mid-April, curreny positions were leaning short USD (and long yen!); these positions were aggressively lengthened in the aftemath of the April 22 G7/IMF communique, which appeared to suggest that the IMF would take a role in co-ordinating currency adjustments to ease external imbalances. (Since then, of course, we've heard nary a peep.)

So the move from 115 to 109 was actually a positive currency traders and a positive for global risk appetite. It was only when the Fed surprised markets on May 11 with the hint of another rate hike that risky assets rolled over. Far from losses incurred as USD/JPY moved from 115 to 109 causing equity selling; macro traders lost money as equities went down and USD/JPY went up!

As proof, Macro Man offers the chart below, which plots USD/JPY and the Barclay currency trader index, a composite of 106 currency funds and CTAs. Note the sharp rise in profits that accompanied the shrp decline in USD/JPY! The resumption of a negative correlation between the two series (on the chart) by late June suggests that that is when the carry trade was re-established.

Elsewhere, Macro Man took profits on his short Bund strangle this morning at 0.35. The market has tilted towards a more dovish viewpoint on the ECB; should Trichet drop the hammer of vigilance tomorrow, we could see Bunds ease back towards a 114 handle.

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