Turning Japanese

After last week's eventful developments, market interest and activity appears to be pausing for breath, at least until tomorrow's quarter-end. While certain enterprising retail establishments may already be gearing up for the Christmas/holiday season, one can only hope that financial markets are not sliding into their usual late-year lethargy.

Given the strong October seasonality and continued uncertainty over America's economic and monetary trajectory, there would appear to be little danger of market stagnation over the next few months. Indeed, a few interesting nuggets have emerged over the last day or so that warrant mention, as they once again suggest that de-coupling, at least financial de-coupling, does not appear to be happening:

* Warren Buffett to buy a stake in Bear Stearns? Rumour has it that the Oracle of Omaha and some Chinese banks, among others, are looking at taking a chunk of Bear. Such a transaction could ignite a rally in the financials, which have badly lagged the SPX recovery to date. (Disclaimer: Macro Man owns a bit of BSC p.a.)

* UK house prices have risen 0.7% this month, according to Nationwide Building Society. This was more than expected and should help calm, at least temporarily, fears that the UK housing market is set for a lemming-like leap off the white cliffs of Dover. Meanwhile, nobody took the BOE up on its recent offer to lend £10 billion at the penalty 6.75% rate.

* On the flip side, yesterday the ECB lent €3.9 billion to an unnamed bank at a punitive rate, suggesting that turbulent undercurrents continue to swirl below the apparent calm in money markets. Month end could provide a few fireworks as banks try to tart up their balance sheets...then again, maybe it won't . We'll know soon enough, however.

Given the relative quiet, Macro Man thought it might be interesting to review the situation in a country where he has significant market risk but has, alas, taken a rather laissez-faire attitude towards his positions. The clue is in the title of the post, as he is of course referring to Japan.

This week saw the annointment of Yasuo Fukuda as prime minister, an event which, by all accounts, places the reforming vigour of Junichiro Koizumi more firmly into the rearview mirror. While Fukuda has retained a majority of Abe's Cabinet ministers, that is not necessarily any great thing. And his appointment represents, from everything Macro Man can tell, a return to the factional, behind-closed-doors dealmaking politcal environment that dominated Japan in the decades prior to Koizumi's election.

In any event, Macro Man has sigificant alpha portfolio risk in short JGBs, with a bit of long yen and long vol risk as well. Of course, the beta portfolio is short yen, so all-in directional FX risk is a moveable feast. That being said, it's worth reviewing the macro situation.

BOJ governor Fukui's term ends next spring, and it is widely believed that he would like to hike rates at least one more time before his departure. To date, CPI inflation has prevented him from doing so, as both headline and core CPI have been negative y/y for most of the year. However, as energy price base effects recede, it is perhaps possible that we see CPI back positive soon. This could be all a trigger-happy Fukui requires to hike another 25 beeps.
Certainly underlying price pressures would appear to be greater than suggested by CPI. Wholesale prices and corporate services prices are both rising, with the rate of change steadily increasing over the past several years.

Of course, the actual output data has been pretty miserable. Q2 real output fell 0.2%, and H1 growth was the worst of the G3. So much for de-coupling... But beneath the surface, some portion of the weakness is probably attributable to an inventory correction, which appears to have run its course. Machinery orders have picked up, and Japan's leading indicator has surged over the last couple of months.

Of course, the flip side to an inventory correction has been a sharp drop in import growth. Coupled with a hyper-competitive yen (against the euro, for sure), this has driven Japan's adjusted trade surplus to new cyclical highs. While Macro Man has previously argued that the small size of Japan's trade surplus was an argument for yen weakness, or at least no yen strength, that argument no longer appears to hold water. Recent trends in Japanese trade would appear to suggest a fundamental rationale for yen strength.
As an aside, this development will make it much harder for Japan to justify massive FX intervention to its G7 partners if they come in anywhere near the levels that have triggered MOF/BOJ dollar-buying over the past decade.
So how are we left? In a situation where Japanese growth and inflation may be poised to surprise to the upside. But this is a fairly low-conviction view, and Macro Man is keen to avoid selectively asserting this view simply because his positions would benefit from it. What is clear is that he really dropped the ball on the short JGB position, turning a tasty gain into an irritating loss over the past couple of months.

Macro Man is keen to avoid repeating this mistake. There's quite a bit of data to be released over the next week; from here on out, the JGB short will have a considerably shorter leash than it has in recent months. As for the yen, it has been driven lower this week by the houswife branch of the DOTW and by half-year-end flows into investment trusts. While there are stories circulating of the post office switching enormous sums of money out of bonds and into equity (some of which will be foreign), that is unlikely to drive near-term price action. USD/JPY above the 116-117.25 region may prompt a re-think, but for now Macro Man cannot help but think that the balance of risk lies in favour of a moderately stronger yen, at least against the buck.

Elsewhere, the nominal P/L has eked back into positive territory on the month, though there's still a crucial period of trading to come. USD/GCC appears to be undergoing a bit of short-covering after yesterday's SAMA non-event, and it seems reasonable to expect that that may continue until next week. Macro Man will look at layering shorts then. Markets still need something to talk about, though, so revaluation focus as switched to Hong Kong. Plus ca change...
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Anonymous
admin
September 27, 2007 at 1:16 PM ×

Out of the recent data flow, I thought the upside surprise on the trade balance and the continued trade mix shift toward Asia and away from N. America was interesting... If the "core" scenario of US rate cuts driving global reflation plays out, Japan could be a one of the key beneficiaries. Isn't long NKY unhedged a better trade than short JGBs for this environment? Especially, with the relatively steep curve.

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Corey
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September 27, 2007 at 1:39 PM ×

buy stop is in at $747.20 (dec basis). this morning's action is exactly the type of momentum i wanted gold to recruit before recommitting - now i just need the new high print.

re: yen. i've been a huge fan of the yen for the trade weighted currency play against the usd. it has also served as my "risky asset" hedge on my long gold position. my contention has been that the dxy would not make new lows unless the yen started perking up...90 yen per usd seems plausible, maybe even low 80s. how nice would it be too, if the carry unwind excuse went away in favor of just yen has been going up on its own merit

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Anonymous
admin
September 27, 2007 at 2:01 PM ×

Would love to read your thoughts on the future of the HK dollar, say, 5 to 10 years out...

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Macro Man
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September 27, 2007 at 2:11 PM ×

Anonymous #1: You may be right that the Nikkei is a better Japan reflation trade than JGBs. But by the same token, other equities are a better reflation trade (in terms of expected absilute return) than the Nikkei.

JGBs, meanwhile appear to be a better short than other bond markets, despite the relative steepness of the curve. Voldemort, et al don't touch the JGB market, and if this post office story is true, they may have quite a few to go as well. Plus, on a rather prosaic basis, JGBs are that much closer to all time highs, in which case there'd appear to be less upside...so I continue to like them as the hedge to the TIPs position.

Corey, the limpness of the buck, to say the least, does indeed suggest that gold should get back on its horse. I employed a similar startegy in entering my modest GCZ7 long. The one downside of paying the high is if there is no follow through...in whcih case you've paid the high!

Anonymous #2, I'd have to assume that as Hong Kong eventually becomes subsumed iunto Greater China, the HKD will eventually become subsumed into the RMB. Whethere that happens in 5, 10, or 50 years, I really do no know. For the time being, I'd suspect that the peg would hold....because if they're going to break/change/abandon the peg, why not just merge the two currencies? The last thing China wants or needs is fighting off speculators in two currencies...

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James
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September 27, 2007 at 3:59 PM ×

Hey Macro Man,

I was thinking about your post yesterday regarding fx and interest vol not priced for a larger move in the dollar and for the life of me I cant figure out why the market isnt making much of the dollar. The euro is crawling higher. Perhaps CB's are still trying to prevent massive adjustment.

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Macro Man
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September 27, 2007 at 4:18 PM ×

My sense is that people have looked at the dollar as a sideshow, and as such a) haven't allocated much risk to the trade, and b) have been quick to take profits when they see 'em.

There was pretty large liquidation of long euro call positions earlier in the week when EUR/USD dipped down to 1.4050.

My view is that the buck should begin to take center stage, which will lead to a greater interest, broader participation, and more aggressive targets (eg, less rapid profit-takes.) Time will tell if I am right...but I see a mroe fundamental reason to "own" this trade now than was the case this time last year.

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macro fan
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September 28, 2007 at 12:57 AM ×

Careful with that toaster folks...

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The dollar
Slip-sliding away

Sep 27th 2007 | WASHINGTON, DC
From The Economist print edition
How low will the greenback fall?

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