While everyone has been focused on the outcome of the fiscal cliff negotiations there has been a far more interesting development occurring in Japan. I believe this development has had a greater impact on the direction of markets over the last couple of months than most people appreciate.
Shinzo Abe, the new Prime Minister of Japan, has made it very clear that he supports more money printing and a weaker Yen. The lead up to his election saw a very sharp move to the downside in the Yen and this strong trend has continued after the election.
The reason why I find this so fascinating is that the monthly chart of the Japanese yen in US dollars is now looking quite scary indeed.
The chart above goes all the way back to 1979. You can see quite clearly that the highs made in 2011 have now created a double top or ‘false break’ of the high made all the way back in 1995. The uptrend from 2007 has also been clearly broken now.
From the look of the chart above and the determination of the Prime Minister to attempt to print his way to prosperity, we may still be at the very beginning of a large move to the downside in the Yen.
This new development is worth keeping an eye on because the Yen has been a favourite amongst the ‘carry trade’ set for many years. The last few years saw a switch from the Yen to the US dollar as the borrowed currency. But we may now be witnessing a return to the old ‘Yen carry trade’ game.
If you’re not familiar with the term, a carry trade is when an investor borrows money in one currency and then sells that currency and invests the money offshore. While the borrowed currency weakens and asset markets rise elsewhere this trade can reap incredibly huge rewards for those able to borrow large sums at very low rates. ie. the banks and hedge funds of the world.
If the Prime minister of the country has made it clear that he has your back and will keep printing money and weakening the currency, why wouldn’t you borrow in that currency and invest elsewhere? It’s a no-brainer that the Yen will continue weakening, so half of your risk has been taken of the table and if anything will ultimately add to the profits.
We have all heard of the risk on/risk off mentality of markets. A good proxy for this risk on/risk off idea is the Euro/Yen and the AUD/Yen cross rates. You’ll often see quite a high correlation between these two currency crosses and equity markets.
It’s sometimes hard to get your head around, but looking at a chart of the Euro/Yen and the ASX 200 shows a striking correlation. There is no doubt they will both diverge at different times but ultimately the relationship comes back into play and the divergence between the two can often be a great hint about future direction.
It’s obvious from the above chart that the rally in the Euro/Yen over the past few months has been amazingly strong. Could the 10% rally we’ve seen in the ASX 200 over the past month be due to this ‘Yen carry’ effect rather than anything else? I think so.
It makes more sense that there is an even higher correlation between the AUD/Yen and the ASX 200. There have been times in the past few years when the AUD/Yen and the ASX 200 have walked side by side with a correlation of almost 1.
That high correlation broke down in early 2012 but the last few months have seen the relationship return.
Just to make the point that there is a lasting relationship between the AUD/Yen and our equity market I thought I should include a longer term chart of the two.
You can see from the above chart that over the last 13 years there has been an incredibly close link between the two, even if there are periods of a year or so when the two moved in opposite directions.
So it appears that the decisions of the new Prime Minister in Japan have far more influence over the direction of our equity market than most would imagine. If he is really determined to trash the Yen does that mean our market will continue rallying? Perhaps.
But as always there are unintended consequences to the actions of our fearless leaders. They are determined to defy all of the laws of economics in their quest to ‘fix’ the economy.
One interesting development in Japan is the little wiggle in the tail of the Japanese government bond (JGB) market.
You can see from the above chart that the 30 year JGB’s have sold off since the middle of 2012. The move has seen yields rise from 1.75% to just over 2%. A yield of 2% is of course still incredibly low, but the fact is a 25 basis point move from 1.75% is not negligible.
You can also see from the above chart that the 10 year bond yield is also starting to move higher over the last couple of months.
Could the bond market be sniffing the possibility of inflation down the track?
What happens to the finances of Japan if the bond yields continue to rise?
Well they have about 240% debt to GDP and an article on CNBC.com stated that:
‘Andy Xie, an independent economist, agrees that Japan’s debt situation is not sustainable and that the country is becoming increasingly reliant on foreign capital flows. Even though the yield on 10-year JGBs is less than 1 percent, the interest expense is expected to top 22.3 trillion yen ($280.6 billion) in the current fiscal year, Xie said.
‘”This is one-quarter of the budget,” he added. “If the bond yield rises to 2 percent, the interest expense would surpass the total expected tax revenue (this year) of 42.3 trillion yen.’
So we can now see that the new Japanese Prime Minister is playing with fire.
He has to tread very carefully if he is to print enough money to weaken the Yen and increase exports, but not so much that he scares the bond market and brings the whole house of cards tumbling down on his head.
In other words, he has to get things ‘just right’.
If anyone needed to ask the advice of Goldilocks it’s the new PM of Japan Shinzo Abe. And I assure you when the music stops it will be more than three bears chasing him into the woods.
Editor, Slipstream Trader