How to Play Currency Moves in Wake of Japan Earthquake

By Keith Fitz-Gerald

According to Biriniyi Associates, investors threw more than $1 billion into Japanese exchange-traded funds (ETFs) last month -- second only to US energy funds and more than agriculture, large-caps, and mid-cap stocks combined.

They couldn't have placed their bets at a worse time.

Amidst fears of multiple nuclear meltdowns, the benchmark Nikkei 225 Index plunged 10.55% yesterday (Tuesday) after a 6.2% decline on Monday -- a two-day decline of 17% since Friday's devastating 9.0-level earthquake and tsunami. More than $650 billion in shareholder wealth has been vaporized.

(To read Lloyd Khaner's article on how the global economy becomes a new concern, click here.)

As a veteran trader and longtime expert on Asia, it's a story that I've heard countless times: Japan was supposed to regain what it once had -- a vibrant economy that helped lead the world in the years following World War II, and that finally achieved global dominance in the late 1980s.

Somehow, however, that never happened. But it didn't discourage the believers.

Three Views of the Rebound That Never Came

On Thursday, the day before the Sendai earthquake and tsunami, the Nikkei closed at 10,434.38. That means the index is down 73% from its record intra-day high of 38,957.44, reached Dec. 29, 1989 -- just before Japan's so-called "Lost Decade" began in earnest. (Sadly, that term should be listed in the plural -- as in "Decades," with an "s" -- given the perpetual malaise that has defined Japan's economy ever since.)

(To see Josh Lipton's piece on fund managers and Tokyo, click here.)

For some strategists and traders, the expected Japanese rebound was all about currencies and exports. Members of this group believed a weakening Japanese yen and China's growth would transform Japan into an exporting giant. In this role, Japan would become the supplier of choice to the newly emerging economies of the Asia region, the key one being China.

Those subscribing to this argument believed one of two scenarios would make this happen. Either the US dollar was going to strengthen against the yen, or the Bank of Japan (BOJ) was going to begin printing money, which would drive the yen lower against the dollar.

A second group of believers based their expectations of a Japanese economic renaissance on mathematical probabilities and financial valuation.

Japan, this group believed, was undervalued - and in a big way. The US Standard & Poor's 500 Index had shot up 91% from its March 2009 bear-market lows, while the Nikkei managed to tack on only 47% through the same period (through last Thursday, the day before the earthquake). Therefore, the odds favored a continued rebound in Japan's shares, this group reasoned.

(To view Todd Harrison's 31 Observations on the Market, click here.)

A third group of believers subscribed to what I like to call (for lack of a better term) the "coattail theory." Somehow, this island nation that is the world's No. 3 economy would finally pull itself up by the bootstraps of the global inflation that reflates all economies. This is nothing more than a variation of the "rising-tide-lifts-all-boats" theory.

My outlook for Japan has been the same for several years now, and wasn't dramatically changed by the events of last week: The country's huge debt load -- as much as 259% of gross domestic product (GDP) depending on which statistics you believe -- will act as an anchor on its economy, meaning there are better (and less risky) places to put your money.

Absent the earthquake tragedy, Japan's economy might have managed to sputter along at 1% per year. But now -- following the unprecedented $186 billion post-quake infusion by the Bank of Japan -- that country's debt load is obviously headed much higher. And that puts both Japan's growth and its yen at real risk.

In my mind, there's no question that Japan will rebuild and its people will recover. But we can't say the same about the country's currency.

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