The Japanese Yen: Handle With Care

One of the strongest major currencies in the world since the onset of the 2008 crisis has been the Japanese yen. This is a dramatic change of fortune for what had long been — and what should be — a weak currency.

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Take a look at this chart, which tracks the dollar/yen exchange rate. In late 2008, a dollar would buy you 110 yen. Today, a dollar will not buy you even 80. And remember, the dollar has been relatively strong over the past four years. The yen’s performance against the euro or British pound would be even more dramatic.

Anyone who follows Japan must legitimately be scratching their heads in confusion right about now. In a market in which investors have been shunning risk for the past four years, why would the currency of the most heavily indebted major country in the world rise? Japan’s sovereign debts stand at 220% of GDP, and the country has struggled to rein in its mammoth budget deficit. Japan has routinely had budget deficits in excess of 10% of GDP.

What’s more, investors are not really getting compensated for holding yen. Japanese short-term rates have been at or near zero for the better part of two decades, and even the 10-year bond yields a measly 1%.

Have currency traders lost their minds? Perhaps. But the yen’s rise is not so hard to explain when you consider a couple points. First, the yen was the primary funding currency for the assorted carry trades beloved by so many hedge funds. In a typical carry trade, a trader will borrow in a low-yielding currency like the yen and put the proceeds into a higher-yielding currency like Canadian or Aussie dollars or, until recently, the euro or pound.

The trader would make money in two ways. First, they earn an interest rate spread, the difference between their borrowing rate and their lending rate. This is how banks operate in the lending markets as well, borrowing cheaply and lending dearly. But there also is a secondary benefit. These activities of traders tend to create trending markets. Low-yielding currencies tend to trend downward, and high-yielding currencies tend to trend upward. So, in addition to the interest rate spread, traders also enjoy gains from a nice pair trade.

Or at least they used to. A couple things caused this trade to fall apart. First, when the capital markets ceased functioning during the 2008 meltdown, there was a rush by traders and investors of all stripes to deleverage. When the world as we knew it was ending, it didn’t make a lot of sense to owe a lot of money. Traders responded by closing out their carry trades, which caused the pair trade to operate in reverse. They scrambled to buy yen rather than sell them. It wasn’t exactly a short squeeze, but the results were much the same. Buying begets buying, and the former object of intense shorting shot to the upside in 2008 and early 2009, causing the yen to gain on all major world currencies.

So why, might you ask, did the yen not drift lower in the years that followed? Here, the answer is less clear, but a few reasons are likely.

First, the carry trade lost its appeal for a lot of burned traders, and many came to view it as picking up nickels in front of a steamroller; too much risk for too little return. And secondly, the attention of active currency traders shifted to Europe and its sovereign debt crisis, giving the yen some breathing room.

But more fundamentally, the yen now has a lot of competition as a funding currency from other low-yielders, not least of which would be the dollar. In a world in which nearly every major currency yields close to zero, the yen is no longer unique as a funding currency. So those traders that do try their luck at the carry trade have their choice of currencies to short.

Still, even with all of this as explanation, the yen’s persistent rise has been baffling, particularly when you consider that Japan’s exports are down. When you see a trend like this that is hard to explain, you might want to question its sustainability.

Financial writer John Mauldin referred to Japan as “a bug in search of a windshield” in his recent book Endgame, and I consider this an apt metaphor. Japan’s gargantuan debts and deficits have only been possible because of the country’s historically high savings rate — a rate that has been trending downward in recent years and might well turn negative soon.

When Japan has to turn to the international bond markets to fund its deficits, it’s not going to enjoy a 1% yield on its 10-year obligations. No one in their right mind would lend Japan money at 1%. No one in their right mind would lend Japan money at all!

In the rolling global debt crisis, Japan will be the next major domino to fall. When it finally has to access the international bond markets, its yields will rise to punishingly high levels. At that point, Japan will have one of two choices, both of which will almost certainly result in a hyperinflationary meltdown: default or using the printing presses to meet current obligations.

Bottom line: If you are a long-term investor, stay out of all Japanese assets. The risks simply aren’t worth it given the attractive options you can find in the United States and Europe. If you are a short-term trader, get ready. At some point in the next one to three years, Japan could prove to be the best shorting opportunity of your trading career.

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Sign up for a FREE copy of his new special report: “4 Dividend Stocks to Buy and Forget.”

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