“A man should look for what is, and not for what he thinks should be.” - Albert Einstein
In March of this year we released an Insight explaining why we were still bullish on the Japanese Yen. As a summary, our bullishness was centered on the defensive nature of the Yen as a “risk off” currency making it an excellent diversifier for our portfolios. We argued that Japan’s currency had been the beneficiary of their large and persistent trade surplus (e.g. Japan exports more than it imports), the “carry-trade”, and a relatively weak central bank.
Last week we closed out our long Yen position. At the time of our previous post, the Yen was selling off sharply against the US Dollar and many pundits were making the argument that the exchange rate was headed down an irreversible path of long-term devaluation. Since then, the Yen has strengthened a little over 5% against the Dollar and now trades close to the same level where we first initiated our long Yen position. We decided to close out our position in the Yen because our thesis for the original investment has been significantly challenged.
Japan has maintained a long history of being an export led economy with a trade surplus. This surplus has been one of the primary tailwinds to the strengthening Yen against all other major currencies since trading partners must sell their local currency and buy Yen in order to purchase Japanese goods. In late 2008 and early 2009, Japan went from a trade surplus to a trade deficit. This was primarily due to a rapid strengthening of the Yen as investors flocked to the safe haven currency during the heart of the global credit crisis. The strength of the Yen made Japanese goods more expensive during a time when consumers went on “lock down” with their spending which created the relatively unusual trade deficit for Japan. The deficit quickly returned to a surplus in early 2009 as the confidence in the global financial system returned and liquidity was restored.
Japan remained in surplus for the next several years until the 2011 Tohoku earthquake and subsequent tsunami turned Japan into a large importer of materials and energy to rebuild the country and replace nuclear power plants which had been shut down. Our initial assessment was that Japan’s trade deficit would be temporary and return to a trade surplus much like it did in early 2009. This has not been the case as Japan’s trade deficit has persisted through 2012 as the slowdowns in Europe and China have reduced demand for their exports and many nuclear plants remain off-line keeping the import demand for energy elevated.
The carry trade is a term used to describe a financing technique that has been popular with many hedge funds and institutional investors over the past several decades. The general thesis is that one should borrow funds in a currency with low interest rates and use those funds to buy assets in economies with higher interest rates to collect the spread which is also called the carry. The preferred lender of the past several decades has been Japan because of their relatively low interest rates.
The carry trade is a “risk on” trade since it is a leveraged investment. Because of this, carry trades tend to be put on slowly over time but will be taken off or unwound relatively quickly when the market shifts to “risk off” mode. As the old saying goes, “the bull walks up the stairs and the bear jumps out the window.” When a carry trade is unwound, investors all rush to purchase the funding currency (the Yen in this case) to close out the trade. This is one of the reasons why the Yen has acted as a defensive currency over the past several decades.
Unfortunately, the defensive nature of the Yen seems to be getting weaker. Some will point the finger to the structural problems Japan has with funding its national debt (a problem that is only exacerbated by the trade deficit issue we’ve already touched upon), which stands at a nose bleed level of over 200% of GDP. Another explanation might simply be that the developed world is all turning more Japanese. Japan was the first country to embark on non-traditional central bank policy measures after their real estate and stock market bubbles burst in the late 1980’s. Today, Europe and the United States have followed suit as interest rates continue to drive lower while central banks print more money to stimulate the economy. The difference in interest rates between Japan and the rest of the developed world used to be measured in percentage points but is now measured in basis points as everyone is in the same boat. Japan may no longer be the lender of choice for the carry trade because other countries offer similar interest rate levels with higher levels of inflation.
CENTRAL BANK ACTION
Nothing has had a larger effect on asset (stocks, bonds, commodities, & currencies) prices since the credit crisis than central bank policy action. The global economy has never experienced this amount of policy intervention since John Maynard Keynes first introduced the idea of managing the economy from a macroeconomic perspective. All this to say, understanding what drives central bank action is an integral part of investing in today’s markets.
Our thesis was that no central bank would be as aggressive as the US Federal Reserve when it came to unconventional policy such as quantitative easing. We still believe this to be true but also see the tides of change on the horizon in Japan. The Bank of Japan (BoJ) has already announced that it will be targeting 1% inflation in Japan to try to break the deflationary cycle which has gripped their economy over the past couple decades. Some Japanese politicians are arguing that 1% isn’t enough. There is now a group of 140 Japanese parliamentarians from multiple parties that have formed an “anti-deflation league” to actively lobby the BoJ into more aggressive action. The winds of change appear to be blowing through Japan with regards to the aggressiveness of its economic policy.
In conclusion, we still think there are factors in place which could cause the Yen to strengthen against the Dollar, but we also realize that the tailwinds which have aided this trade over the past two decades are weakening. The stubborn trade deficit and potentially more aggressive central bank are both bearish for the Yen. The fact that the Yen is no longer acting as a defensive currency versus the US Dollar makes it less appealing to us from a Diversification 2.0 portfolio construction perspective. In the long-run “Japan is a bug in search of a windshield,” to quote John Mauldin, because of their mountain of debt and aging demographics. We have no idea if or when the tipping point for Japan will occur, but for the time being, we are fine moving to the sidelines with no position in the Yen.
Contributor: Elliott Orsillo,CFA
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.