Japan Election Speculation Makes Yen Bears Happy

Japan will hold a Lower House election on December 16 in which the ruling Democratic Party of Japan (DPJ) is widely expected to lose to the opposition Liberal Democratic Party (LDP). The LDP is headed by Shinzo Abe, a former prime minister, who has called for “unlimited easing” by the Bank of Japan to create inflation and to weaken the yen. Hedge fund traders we have spoken to interpret “unlimited easing” to mean specific inflation targets for the Japanese central bank and unlimited intervention in the foreign exchange market. Once it became clear on Thursday of last week the prime minister Noda was going to dissolve the Diet and call an election, the Nikkei 225, Japan's benchmark stock index, has rallied while, in the currency market, the yen has weakened against the U.S. dollar, further fueling the rally in equities Over the weekend, Goldman Sachs Asset Management chairman, Jim O'Neill, publicly reversed his call on the yen. “From the Plaza Accord of September 1985 all the way until I joined GS in the Autumn of 1995, I was bullish Yen, and after a brief shift to being temporarily US$ bullish, I returned to being a Yen bull from 1997 until a few years ago,” O'Neill wrote. ”I was quite chuffed with myself for understanding the Yen and it was based on pretty simple stuff, Japan's persistent and strong balance of payments, especially its trade and current account surplus, and its associated rising equilibrium exchange rate.” The modest O'Neill continued, ”All of this has reversed and recently, Japan was reported its first ever current account deficit, or certainly, its first for many decades. They have a very overvalued exchange rate, a collapsing export sector, an unreformed domestic economy, a debt challenge that makes Greece's seem easy to solve, a central bank that doesn't try too hard – currently – to reach its inflation target and, once again, a very weak economy…I have been getting more and more negative about the Yen for the past couple of years, and I have, so far, been wrong, but it seems more and more obvious to me, that the moment is here.” OK. If you buy O'Neill's argument, then you should be going long the iShares MSCI Japan Index ETF EWJ and the ProShares Ultra Short Yen YCS. But, before you do, allow me to deflate Mr. O'Neill's ego for a moment. First, the Japanese election outcome is not obvious. The LDP is clearly leading in the election but, polls indicate that the LDP may not win a majority in the Lower House. The LDP already has one coalition partner in the Komeito (Clean Government Party) However, for the first time in decades, there have been several new political parties formed that may gain some traction at the polls. Japan is a parliamentary democracy so elections do not offer an “either-or” choice. Several of these new political parties have joined together for the election. Polls indicate that many Japanese are fed up with both the DPJ and the LDP and may be willing to vote for a third party. If either the LDP/Komeito or the DPJ fails to win an outright majority, the grouping of third parties could form a power bloc that gets to decide who will run the next government by joining a coalition. Would such a coalition be supportive of Abe's more radical ideas on stimulating the economy and weakening the yen? Second, Japan remains mired in a deflationary spiral. The velocity of money in Japan is now only 0.55 which means that every dollar of credit created generates only $0.55 of GDP. Where does all of the other money go? A recent study by the Institute of Monetary and Economic Studies at the Bank of Japan suggests that, during a financial crisis, normal credit mechanisms are disrupted and households find that they cannot borrow money from banks. Households need to save (or hoard, depending upon your point of view) more cash to fund current purchases. If households fear a future financial crisis, then they must save/hoard even more cash for future consumption. In addition, households must pay back the debt that they already have. The end result is sluggish GDP and declining prices despite massive monetary easing. Another point is that Japanese households are much more concerned about the return of capital than they are about the return on capital. Japanese government bonds (JGBs) offer a lot of safety but not a lot of yield. But that is what is important to the majority of people and institutions, who happen to be Japanese, that invest in JGBs. Hedge funds have been shorting JGBs for nearly 20 years and have continually lost money on the trade. So much so that the short JGB trade is called “the widow maker.” I would argue that, for most Japanese investors, forays into foreign currencies have ended badly. At the end of the day, if you live in Japan, you need Japanese yen. For most Japanese investors, it is just not worth the risk of investing a significant amount of money outside of the yen. The yield pick-up just doesn't cover the increased risk. Investors should be wary in case the short yen trade turns out to be “widow maker II.”