I Can't Shake This Feeling....More on USD/JPY

Maybe it's just always been too far afield for me, but I think the Japanese yen is the death star of macro trading. There are a vast number of variables that don’t really apply to other FX markets, and your positions exists at the pleasure of the BoJ, which has the power to open fire with this “fully armed and operational battle station” to destroy whatever planet you are living and trading on. And if that’s not enough, it is the funding currency of all funding currencies. So go ahead, spit into that gale force wind.

But I just can’t shake JPY...and the possibility it makes a big move stronger this year. In the comment section from last week’s post Johno asked the big question for JPY in 2018:

One question concerning USDJPY I may have posed before is what happens if we get inflation >1% in Japan. Some argue that YCC will remain, or slowly adjust, pushing real rates down and with it the currency. Others argue markets will look forward, anticipating removal of YCC, higher rates, and pushing the currency stronger.

I’m in the latter camp. Here’s why. There are a confluence of factors that are pushing the yen towards strengthening.

The economy is picking up in a way that hasn’t occurred in many, many years. I can bombard you with charts on this one, but I found this one to be particularly telling. Credit growth is picking up, and rising significantly while it is flatlining or decelerating in Europe and the United States.

That says to me that there are good investment opportunities in Japan, and now that there are signs global growth might support an increase in export capacity, businesses (both foreign and domestic) are starting to take advantage of that. That might be the beginning of a turn from a very large industrial battleship.

Second, the Yen is cheap. Really cheap. MacroTourist started me thinking along this line a few weeks ago, and I guess I’ll just put my spin on what he said:

JPY has been left behind by every other DM currency in the great USD-fire sale of 2017:

Including against KRW, which has appreciated markedly as the BoK has taken its foot off the intervention pedal, and amazingly, moved to finally hike rates. Tough to envision a break of 9.00 here now that the Korean government is calling time on the strong won.

That’s nominal rates...but real rates, or purchasing power parity valuation, show an even more attractive picture. USD is roughly 20% rich to JPY on a PPP basis.  

And as I have noted in the past (repeatedly, I’m afraid) the BIS real effective exchange rates shows the yen skulking at the bottom of the table for DM FX:

All this, despite the fact there is little evidence of a breakdown in the relative productivity of the Japanese and US economies:

Right...so some mysterious force….the dark side, the light side….we don’t know which...is sandbagging the yen. What could it be?

Yep, it’s this....The BoJ's printing press:

I could argue until I’m blue in the face that a chart like that can’t go on forever--but maybe it could! This gets back to the crux of Johno’s point--will the BoJ keep the pedal to the metal, or will the market price in an easing of this reality TV episode of “The World’s Most Extreme Central Bankers”?  If you poke around the street and “fintwit”, various forces will argue that there is already a “stealth taper” from the BoJ. If you look at their total assets, that might be true, but without any official word from Kuroda and Co., it is hard for me to trade on that.

Many will point to the correlation between stocks and JPY. This correlation raced towards 1 when Abenomics took off in 2013.  That correlation has broken down lately as optimism on the economy and foreign and domestic flows have led the Nikkei to outperform USD/JPY.

Will this relationship mean revert? I guess it could, one of two ways: 1) FTQ….stocks could take a big dump on any number of risk factors. The newly high-beta Nikkei cools off while USD/JPY grinds lower, or 2) Kuroda pulls out the Draghi card and says he’s still going to do “whatever it takes” to reinflate the economy, and the YCC target isn’t going anywhere. The former is a random variable (and positive for long JPY anyway)...the later is possible, I just don’t see it happening.

I think the market will eventually price an easing of the YCC policy more broadly than they do now. Importantly, the odds aren’t “even”...despite accelerating domestic growth, the yen is still the currency traders love to hate.

That leads us to the technicals. Locals are starting to reverse a long period of fleeing local markets in favor of foreign bonds...I can’t find a clean data set showing the history here but the potential repatriation inflow from domestic investors that have fled Japan in favor of foreign markets is massive. If this flow even tips towards balance, it would be hugely supportive for JPY.

Moving to the dark art of CTFC FX spec positioning...despite signs of life across all sectors of the Japanese economy, the short yen position is at a multi-year extreme:

And we remember from 2017 what can happen when the story “flips” in a currency with an extreme and structural short position:

Currencies are a zero-sum game (in DM, anyway)....but here the odds aren’t even. You’re getting good terms to take JPY risk here.

Lastly, there is the tailwind from the dollar and capital flows. After the combination of dormant domestic demand, the Fukushima earthquake, and high oil and food prices crushed the current account early in this decade, the surplus is back, baby!

Just as important, as the American consumer has picked up some speed, the US c/a deficit has started to turn lower again. Historical evidence suggests that the combination of a rising surplus in Japan and a deficit of 2.5% or higher in the US is a negative signal for the dollar.

And indeed, as I noted last week and IPA will be glad to tell us again, there is significant air beneath the dollar here, even after the poor performance in 2017.

And just as an aside, despite my misgivings last fall, I don’t see the structural support for an acceleration in inflation that will trigger a more aggressive hiking cycle, and subsequent USD appreciation--from the FOMC.  Nor do I buy into the policy-driven growth renaissance in the US. The economic surprise index tells me there is more downside than upside there, too.

Putting it all together as we like to say….cheap valuations, attractive positioning, strong fundamentals and potential for positive surprises from both sides of the trade (monetary in Japan, economic in the US) makes for an attractive risk-reward in buying yen.

There it is. The first case I’ve ever made to buy yen. Deflector shields are down, blast away.

Shawn
TeamMacroMan2@gmail.com
@EMInflationista