by Ivan Martchev | June 3, 2013 7:00 am
When Prime Minister Shinzo Abe scored an election victory last December, it was as if a switch was flipped in the currency markets. That was when the yen began its infamous six-month decline — a drop that’s likely not finished given the acceleration of alternative BOJ monetary policies in April.
Such yen weakness has profound implications for the Japanese economy.
I was skeptical of Mr. Abe’s election promises (as one should be of any politician’s) until the implementation of some of his declarations became reality. The reality in this case was the change of BOJ leadership in April, with massive acceleration in quantitative easing policies.
If you look at quantitative easing in the U.S., the Federal Reserve is performing a giant de facto carry trade in which it funds itself with alchemically created QE cash to buy bonds yielding much more than the 0.25% it pays for its excess-reserve funding. Yet, such excess reserves are intentionally designed to not circulate in the banking system, so as to avoid undesirable inflation. QE in the U.S. is designed to stimulate the economy through lower long-term interest rates and thus lower unemployment. In fact, inflation in the U.S. is presently at 1.1%, too low for the Fed’s taste compared to its target of 2% and the average over the past 30 years.
Japanese QE is different, as some of the electronically printed money is designed to multiply in the broader money supply. Japanese inflation has been too low or negative since 1995, putting the Japanese economy firmly in a deflationary stagnation.
At $5.98 trillion, Japan is the world’s third-largest economy, below U.S. GDP of $15.65 trillion and Chinese GDP of $8.25 trillion. Yet the size of Japan’s QE program is almost as large as that of the Federal Reserve’s $85 billion a month in asset purchases. Under newly appointed Governor Kuroda, the BOJ is purchasing 7.5 trillion yen ($78.6 billion) in bonds each month in a bid to double the monetary base in two years. This leaves BOJ’s QE having nearly three times more bang per GDP buck compared with that of the Federal Reserve, if you consider the much smaller Japanese GDP.
The BOJ is trying to perform a controlled increased flow of liquidity into the Japanese economy to achieve its desired higher inflation rate. For example, the BOJ is increasing holdings of exchange-traded funds and real estate investment trusts by a respective 1 trillion yen and 30 billion yen per year, which is a direct intervention in the stock market. Under this unsterilized monetary infusion, the BOJ officially purchased 18.8 billion yen worth of Japanese equity ETFs on the day of the April 23 mini-crash, as well as another 18.8 billion yen of Japanese stocks on the day after the mini-crash.
The BOJ in April also temporarily suspended its “banknote rule.” (Under the “banknote rule,” the BOJ had previously limited the value of its bond holdings below the amount of cash in circulation.)
With a QE designed to be more aggressive and less sterilized than that of the U.S., the BOJ is lowering the exchange value of the yen while hoping to increase the inflation rate. A lower yen is a boon to Japanese exporters and has been a near mirror image of the Nikkei 225, where those famous exporters are listed. (The CurrencyShares Jaoanese Yen Trust (FXY) works as an inverse of the classic USDJPY rate, where more yen per dollar means weaker yen).
Still, the Nikkei 225 index is exhibiting the signs of a one-sided momentum market, where a large number of investors are leaning both long the Nikkei and short the yen. The increased use of leverage is evident in how a small counter-trend move up in the yen on April 23 created such a large (7.3%) one-day decline in the Nikkei … similar in size to the first-day Fukushima selloff in 2011.
Given the yen deluge unleashed by the BOJ, I do not think that the recent (inverse) low of 103.74 on USDJPY will hold for long, which suggests the rally in the Nikkei should resume. I have to remind U.S.-dollar based investors, though, that the Nikkei 225 index is based in yen, so any potential upside of unhedged purchases of Japanese stocks — like those that have ADRs carrying currency translation — will be somewhat offset by the falling yen.
I had previously theorized that one way to deal with the weak yen issue is to consider the ADRs of Japanese securities firm Nomura (NMR), whose business model is leveraged in a major way to a rising Nikkei. Investors might also consider Mitsubishi UFJ (MTU) and Mizuho (MFG), whose business models are leveraged to increase lending and less NPLs with potentially fading deflation.
An interesting index approach in this case is offered with the Wisdom Tree Japan Hedged Equity (DXJ) ETF, which hedges its yen exposure so that U.S.-based investors see performance from the ETF as if they are based in Japan and are buying a local-currency ETF. Since this yen decline started, DXJ has behaved very differently than the unhedged iShares MSCI Japan Index Fund (EWJ), which reflects the weaker yen.
All of the above considered, the yen decline likely is not over, which means the Nikkei has further to rally. The QE maneuver, though, is so much more aggressive than the Fed’s that there is no room for policy error. And central bankers, be they in Japan or the U.S., are not known for perfection, if you review their records from the past 20 years.
I wonder: If the BOJ succeeds with its 2% inflation target, what gives it such certainty that it can stop and not massively overshoot?
Ivan Martchev is a research consultant with institutional money manager Navellier and Associates. The opinions expressed are his own. Navellier and Associates holds positions in Nomura Holdings and Mizuho for some of its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser before making any decision to buy or sell the aforementioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.
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