The Ex Ante Factor: Endaka
Written for members on February 10th.
This week dollar bulls and bears had plenty to chew on from Warren Buffett's bearish outlook, somewhat dovish rhetoric from Trichet, a BOE 25bps ease, a $170b stimulus plan out of Washington and this weekend's G-7 meeting. In past articles where we have made a bullish case for the US dollar we have pointed to the EURUSD pair as potentially the main beneficiary of a dollar rally. While we maintain our bearish position on the EUR we wanted to turn our attention to JPY and specifically the yen carry trade which a year ago was on everyone's radar but now seems to be back page news.
There is no doubt the unwinding of the yen carry trade has exacerbated the recent period of de-leveraging. After all, by nature of the carry trade, much of the leverage was financed in yen. This is evident when looking at the simultaneous 6/07 tops and subsequent increased volatility in USDJPY, GBP/JPY and EURJPY. In fact the topping of these pairs a month prior to the top in equities supports the notion that the unwinding of a major leveraged position was the first domino to fall. Most of the bodies are buried in US, Euro and British banks and it should be no coincidence the "Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund" was unraveling at the same time these currencies were topping.
Since that bottoming in yen and unwinding of carry trades, the yen has gained 18% v the dollar. Over the same period the euro has gained just 9% with sterling virtually unchanged. Arguably one of the biggest factors holding back a rally in DXY has been the yen and pressure from de-leveraging. The COT data from the CME show large speculators were net short over 150k contracts in the final weeks of 6/07 but aggressively reversed and are now net long over 50k which has been a rare position over the past few years. This suggests hedge funds have largely unwound their yen carry trade positions.
Endaka: high yen recession. A state in which the yen is high, or valuable compared to other currencies. Since Japan is highly dependent on exports, this can cause a recession.
There is one major drawback to the rising yen. It has a depressing effect on the Japanese export led economy which has been fighting deflation ever since their real estate/banking bubble popped 20 years ago. Recently there was hope Japan was turning the corner but with the Nikkei down 28% from last year's high and recent economic data displaying weakness the authorities may find it necessary to join the US and stimulate the economy. With interest rates already near zero the BOJ may find selling yen as a more effective tool. We aren't necessarily forecasting such intervention by the central bank but note we are approaching the par level on JPY which marked bottoms in early 2000 and early 2005 suggesting we are near an extreme level which may raise the odds of a monetary reaction.
As we take a look at the euro/yen and dollar/yen charts we can't help but notice these two distinct support lines. Since the 1995 highs, yen has pulled back in a long consolidating pattern that resembles a triangle.
One interpretation has the yen finishing off the final leg of a triangle which typically precedes an explosive reversal. As the yen rallies into resistance with large speculators unusually net long and the potential for BOJ intervention, we think the risk/reward is favoring a reversal. When taken with the fact that euro/yen seems to be holding this long term trend line from the 2000 low we are on the lookout for a high in yen, a reversal and potential reemerging carry trade potentially blessed by the BOJ. This could have a net positive effect on risk premiums and asset values.
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