Thursday, 28 March 2013

Japanese Yen Production Begins Next Week

Ralph Shell, Excel Analyst

Prime Minister Shinzo Abe's main man in the deflation fight, Haruhiko Kuroda, takes his position as the new central bank governor for the Bank of Japan (BOJ) next week.  If we are to believe the action of the yen in the currency markets, the Abe-Kuroda team is headed for the monetary hall of fame.

The problem with the Japanese economy has been deflation.  According to the Wall Street Journal:

"Since 1998, Japan's consumer prices have dropped to 1992 levels. Wages are down 7%. Urban property prices are down 51%. Tax revenues are down 14%."

Deflation hurts the economy in many ways.  Consumers postpone purchases, waiting for cheaper prices in the future.  Economic growth slows, as do tax receipts.  The biggest problem, however, is that debt must be paid off with more valuable money.  Japan, with sovereign debt about 245% of GDP, cannot afford to repay this debt with a more expensive yen.

The goal set by Abe for Kuroda is inflation at 2% per year, and as quickly as possible.  Mr Kuroda's predecessor Shirakawa says this cannot be done, and others say this should not be done.  From The Telegraph:

"A debt ratio of 245pc of GDP is not really safe, and it is not happening because we are investing," said Takehiko Nakao, Japan's 'Mr Yen' or vice finance minister in charge of the exchange rate.
Mr Nakao said the scope for further fiscal stimulus is running out and the country must restore public finances to a sustainable path by the middle of the decade. "We can't continue to expect people to lend money to us."

And who will lend money to the Japanese if the inflation rate goes up to 2%?  Currently, the yield on Japanese Government Bonds is low.  The yield is a mere .12% on the five-year note, and .52% on a ten-year bond.  This compares to 1.83% for the ten-year in the US, and 3.52% in Australia. 

This may be one of those cases where the cure is worse that the disease but so far this has not been the case.  For example, the bearish Japanese note fund (NYSE:JGBD) is trading lower.  The total Japanese sovereign debt is about $23T so there should be ample offerings of debt in the secondary markets.  Will this continue when the newly-minted yens hit the market?

Anticipation of the results of 'Abenomics' has produced positive results, in addition to the sell-off in the yen.  The Nikkei 225 is up from 10,150 in the middle of December to a high of 12,635 this month.  Times are good.  Mizuho Financial Services will hire new people and increase bonuses, and other firms will pass out increased bonuses.  The bull run in equities has had another inflationary result.  Prices of golf memberships at private courses has gone up by about 11% this year.

Preparations are being made for the new BOJ to 'hit the ground running' with their bond purchases.  The two asset-purchasing facilities under the previous governor are going to be consolidated.  There was an asset-purchasing program established in 2010 designed to purchase government and corporate bonds; currently, there is ¥27T of assets in the fund.  It will be their goal to increase this by ¥17T for a total ¥44T by the end of the year; this amounts to about $20B per month for the remaining nine months in 2013.

The outlook for the Japanese economy and the yen has been negative.  Japanese exporters have been weakening, in part because of the elevated currency.  There has been some alleviation of this problem, but not before exports slipped and Japan has posted her first trade deficits for decades.  The economy, in part because of the aging population and the elevated yen, has been slow to recover.  Perhaps the increased money supply combined with some public works spending programs will turn the economy around.

Will the actions of the new BOJ be vigorous enough to satisfy the yen bears? 

Judging from the last COT report, there is an abundance of bears.  But they have made money in those positions.  Some are talking much lower numbers for the yen (FXY, UUP)  versus the USD.  Quite often, I like to be a contrarian when the market is loaded with bears, but there are a couple of reasons why I still like that side of the market.

Click on Chart to Enlarge

First is the interest differential.  With rates less than .60% for ten-year bonds, money will continue to fly out of the country.  Also, there will be little incentive for corporations to repatriate profits.  Corporate tax rates are 38% through 2014, and 35.64% in 2015.  High current rates and the chance of a depreciating yen favor keeping money abroad.

Longer term, should the Japanese inflation rate go to 2%, where will the interest rate be? Certainly, they cannot stay at current levels.  So we go back to where we started.  The government will not be able to borrow money at affordable rates.  The cure will be worse than the illness.

Click on Chart to Enlarge

The bear yen market has been a long time coming, having worn out many traders before it even started.  If you are without a position in this run, it is hard to know when to get in, but I suspect weakness can still be bought.  As always, manage your money.
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