Marco Pivot Point
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There are a number of advantages to having a strong currency but short-term export growth is not one of them. Japan is at an interesting crossroads as the events in Europe play out. The strong appreciation of the Yen versus both the U.S. Dollar and the Euro is obviously making it difficult for Japan to goose net exports via currency devaluation. So far they have resisted further easing to cheapen the Yen and given the size of the storm brewing in Europe and the U.S. it would be folly to try and hold back that tide. The abysmal non-farm employment payroll report from the U.S. Bureau of Labor Statistics sparked a new round of safe haven money flows, as Gold exploded, the German DAX Index imploded, and money rushed into government bonds with flow leaking towards Japan.
Since this deflationary phase began in early March and the price of Oil peaked on March 14th, the price of Asia-Pacific Minas Crude, a proxy for lights sweet crude, has fallen 17.3% while A-P Tapis crude has fallen by 20.1%. Add to this the Yen’s appreciation versus the Dollar and Japan is paying more than 26% less today to import oil, one of its major imports than it did in March. The United States Brent Oil ETF (NYSEMKT: BNO) has plummeted 21.7% and looks like it will test its early October low of $66.80 per share.
This drop in oil prices helps offset Japan’s wage imbalance while providing a massive incentive for their multinationals to accelerate their regional investment. This reinvestment will, however, take time to produce benefits as the Nikkei 225 has sold off 17.2%. The MAXIS Nikkei 225 Index ETF (NYSEMKT: NKY) has dropped, trading at a multiple of 11.7 from a peak of 13.5.
The Opportunity Presents
June 1st marked open exchange between the Yuan and the Yen. Moreover, China has announced that they would accept a greater percentage of Yen into their foreign exchange reserves, presumably at the expense of the dollar. This is clearly a vote of confidence in the Yen and another signal that other major economies are tiring of having to do the Fed’s heavy lifting. Since that announcement was made the Yuan depreciated versus the Yen 3.2% in four days.
When we add to this the advent of oil futures trading on the Shanghai exchange which can be settled in both Dollars and Yuan a clearer picture of the grand strategy presents itself. While that contract will not be ready before the end of the year this does represent a move which allows both China and Japan to sell dollars into a rising market while replacing them with each other’s currencies.
Even if Europe settles down and a framework is put in place to stop the bleeding of periphery debt, which would allow money to flow back into the Euro, that would not fix, at all, the situation in the U.S. If anything it would re-focus the market on the real problems there and some of the safe-haven flows the U.S. bond market has received will reverse itself. This should keep upward pressure on the Dollar-Yen cross, traded as the CurrencyShares Japanese Yen ETF (NYSEMKT: FXY).
Balance Sheet Repair
A lot is made of Japan’s huge debt to GDP ratio but remember that unlike the U.S. the Japanese more stringent accounting regulations account for government retirement obligations. When Social Security and Medicare are factored into the equation, the U.S. is closer to 400%. Japanese corporations and households have reduced their combined debt to 1988 levels. As well, return on equity and return on invested capital for Japanese corporations is starting to rise.
Of Government Bondage
Yes, the government is indebted, but as the 2nd ugliest duckling currently, behind the U.S. Dollar, the Yen is the only market big enough and the Bank of Japan the only central bank powerful enough to absorb the demand that is coming its way. The JGB market is nearly 70% of the U.S. bond market in size. But, the market is beginning to handicap a change in sentiment between the U.S and Japan.
CDS spreads for U.S. debt have risen 65% in the past two months, rising to 48 basis points from a low of 29. On the other hand, JGB 5 year CDS rates have risen just 6.5%. Yields have collapsed as well, 37% for U.S. 10 year notes and 21% for their Japanese counterparts. These safe-haven moves have burned those short the iShares Barclays 20+ Yr Treasury Bond ETF (NYSEMKT: TLT) badly having risen 17%.
None of this is to say that Japan’s fundamentals are fantastic, but they are improving. Lower energy costs, massive safe-haven inflows along with new avenues for yen liquidity place them in an interesting position in the coming months to begin a new phase of regional investment while taking on more responsibility as the Pacific Rim’s reserve currency. Look for Japanese investments in distressed assets all around the region to soar.
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