The Yen Black Swan Revisited

Now can possibly plan for my next trip to Tokyo come June.

WSJ: The Japanese yen, after a long period of strength against the dollar and the euro, is finally giving up ground, providing relief to Japanese exporters and a boost to Tokyo stocks.

Reuters

The dollar hit a three-month high against the yen Thursday at 93.73 yen, and is now in positive territory against the Japanese currency for the year, up 0.6%. The yen has now lost roughly 10% of its value against the dollar since reaching a 14-year high of 85 yen to the dollar last November. Even the beleaguered euro reached at its highest level against the yen since early February at 126.62 yen.

"Our view for quite some time is that the yen deserved to be weaker," said Paul Mackel, currency strategist at HSBC in London. Yen weakness has more room to run, he said. "It's been an abrupt move already, and I don't think the market is on it fully quite yet."

The yen's slide will be welcomed by Japanese politicians and exporters who prefer a weak yen to make Japanese goods more competitive on the world market. It also blunts the effect of deflation by making imported goods more expensive for Japanese buyers and reduces expectations for falling prices that make consumers less willing to spend.

The weaker yen sent Japanese stocks higher Thursday. The Nikkei Stock Average of 225 companies rose 1.4% to 11244.40, and has now rallied 6.6% for the year to an 18-month high.

In another bit of good news, the Bank of Japan's tankan survey showed that Japanese business sentiment improved for the fourth straight quarter in the three months to March, thanks to strong overseas demand for Japanese products. The tankan's headline business-sentiment index for large manufacturers, which measures the percentage of companies saying business conditions are good minus those saying conditions are bad, recovered to minus 14 from minus 25 in the December survey.

The weakening yen could add to that sense of confidence among exporters. Japanese companies had been preparing for a prolonged period of yen strength this year and might now find a changed currency landscape. The tankan survey says companies are planning for a dollar level of 91 yen. It is now getting close to 94.

For every one-yen rise in the dollar above 90, Canon Inc., the Japanese maker of digital cameras and printers, says its operating profit will increase $91 million. Sony Corp. says its operating profit would increase $11.1 million.

Koji Endo, an analyst at Advanced Research Japan, estimates a rise or fall by one yen against the dollar either lifts or reduces Toyota Motor Corp.'s annual operating profit by 25 billion yen ($267 million). To put that in perspective, a 1.5 yen slide against the dollar is enough to erase Toyota's expected 20 billion yen operating loss for the fiscal year that ended on March 31.

A one yen move either boosts or slashes Honda's annual operating profit by 15 billion yen and Nissan's by 10 billion yen.

The yen's slide also helps Japan's exports to China, an increasingly important market for Japan. China has maintained a de facto peg against the dollar since July 2008, so a drop in the yen versus the dollar is also a drop against the Chinese renminbi. Counting the U.S., China and Hong Kong, which also maintains a peg to the U.S. dollar, nearly 40% of Japan's exports go to markets where the dollar's level is a critical factor in determining competitiveness.

The yen's direction has fooled investors before and some prominent analysts and commentators forsee a rebound in the currency. Japan still has a strong trade surplus, which creates demand for the yen. Former Ministry of Finance official Eisuke Sakakibara, said last week the dollar could to retreat to 85 yen at some point in the near future.

Interest-rate expectations in the U.S. are among the most important factors in determining the dollar-yen relationship, says Barclays economist Yuki Sakasai, in Tokyo. "The consensus is that U.S. yields are going higher. This is why dollar-yen went up so high recently," he said.

U.S. interest rates moving higher compared to Japanese rates attracts Japanese savers, including institutions such as insurers and pension funds, into U.S. bonds. As U.S. Treasury yields poke higher, as they started to last week, Japanese investors start converting yen to dollars.

The dollar rally against the yen has also coincided with the end of the Japanese fiscal year on March 31, a time when Japanese corporations stop their annual repatriation of foreign profits by converting them into yen, which had kept demand for the currency high. A new fiscal year is also a chance for Japanese investors to reset their strategies for sending capital abroad, and for Japanese companies to set hedging bets for the coming year.

Another factor is the so-called carry trade. When Japanese interest rates are considerably lower than in the rest of the developed world, investors borrow in yen to buy into currencies with higher interest rates. Now that U.S. rate expectations are going up, and the Japanese central bank continues to ease monetary conditions, investors are expected to use the yen again as a funding currency for the carry trade.

Brown Brothers Harriman analyst Marc Chandler figures if the dollar breaks above 94 yen, because of the way investors place currency bets, the greenback could more easily extend its run as high as 96 or 98 yen.

And the yen decline seems to be broader than just its relationship with the dollar. It is down against the euro, and the Canadian and Australian dollars.

"While the market was fixating with Greece and how bad it was for the euro, the real story is you are seeing yen weakness emerge against a broad range of currencies," said Mr. Mackel of HSBC.

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Wednesday, January 27, 2010

My #1 Black Swan In 2010

While the whole black swan thing sounds interesting, how are we to make a conscious effort to incorporate it into our analysis? Let's look again at Taleb's thesis:
... the existence and occurrence of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations. Taleb regards almost all major scientific discoveries, historical events, and artistic accomplishments as "black swans"—undirected and unpredicted. He gives the rise of the Internet, the personal computer, World War 1, and the September 11 2001 attacks as examples of Black Swan Events. To a large extent, the subprime crisis is another prime example of a Black Swan.

"What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. I stop and summarize the triplet: rarity, extreme impact, and retrospective (though not prospective) predictability. A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives."

Taleb contends that banks and trading firms are very vulnerable to hazardous Black Swan Events and are exposed to losses beyond that predicted by their defective models.

So, what's my #1 Black Swan so far for 2010? I have a few, but I will share with you the one on the top of my list. Japanese yen may go in for a huge devaluation in 2010. During the risk aversion period, many people flocked to the yen currency. Seriously, for an economy still grappling with the excesses of the late 80s and early 90s, and going into a deflationary mode, you don't need a strong currency.

Why is this a black swan? Most people assume that Japan should not have a strong currency. Its zero interest rate policy has not been working but most will assume that it may go back from 90 to 100 at the most vis-a-vis the USD. The biggest catalyst has to be the mega government deficit that Japan has. Japan being Japan is doing tai-chi on that issue. The tons of fiscal stimulus pumping over the last few years have not budge the economy. The budget deficit is unsustainable.

S&P: The outlook on Japan was revised to negative on diminishing economic policy flexibility, and ratings were affirmed at AA/A-1+. At a forecasted 100% of GDP at fiscal year end March 31, 2010, Japan’s net general government debt burden is among the highest for rated sovereigns. The ratio of gross government financial debt to GDP is already around 170% on a general government basis (i.e. central and local government and social security funds) and is the highest by far among developed countries (OECD average was 75% in 2007). Moreover, the policies of the new Democratic Party of Japan (DPJ) government point to a slower pace of fiscal consolidation than previously expected. Combined with other social policies that are not likely to raise medium-term trend growth and with persistent deflationary pressures, Japan’s net general government debt-to-GDP ratio may peak at 115% of GDP over the next several years.

Many think that the yen carry trade is done by big hedge funds, but there are a substantial number of Japanese individuals who have borrowed in yen to invest overseas. A weaker yen will reverse that trend.

The key here is many think Japan's fiscal deterioration is a given but also note that Japan has a AA long term rating. A catalyst could come from a few rating agencies downgrading Japan, or Bank of Japan engineering (or allowing) the yen to fall. A major catalyst should be if/when they decide to make a landmark decision on how to tackle their outstanding debt. Its a time bomb because the yen's un-natural strength is largely due to the subprime mess but is dragging Japan into a recession if its allowed to continue. The shock could be exogenous (e.g., a rating agency putting a major AAA-rated country on negative watch) or endogenous (e.g., failure to match supply and demand on a major sovereign issuance). These fears actually emerged on several occasions in 2009, but were not amplified by massive sell-offs as occurred in 1994, despite far higher volatility this time around. The actual catalyst may not even have to come in a downgrade of Japan's ratings, it could be triggered by a major downgrade of another country's sovereign rating.

In 2009, downgrades and debt auction failures in countries like the UK, Greece, Ireland and Spain were reminders that advanced economies are not immune to being reprimanded for "poor fiscal fundamentals This year, the "pervasive negative big issues" should be: a weak economic recovery and an aging population, translating to a focus on the increase of the debt burden of many advanced economies, including the U.S., UK, Japan and several eurozone countries.

The weaker yen should happen because Japan does not have foreign currency debt, and the "devaluation" would not hinder their debt absolute value. Key implication of all estimates of Japan's debt is that without increasing the national tax burden (i.e., tax and social security costs)—which is relatively low compared to other major countries—it is impossible to sustain public finances. Unfortunately, raising taxes would curb already weak domestic demand.

Wafer-thin interest rates make it cheap to issue bonds, but the Japanese have decreasing incentive to invest in Japanese government bonds. If Japan must start selling more debt to the foreign market, interest rates may rise to attract any investors. If the market demands an interest rate of anything more than 3.5% then Japan will not have the [tax] revenue to service its debt. Even without a weak economy, Japan's debt numbers are set to get worse because of its aging population and underfunded public pension fund.

Not all black swans are negative events, and in this case, I think the yen can go back to 120 level, literally overnight. When that happens, we will have a chain reaction:
- Japanese stock markets will boom as exporters benefit immediately and companies can be a lot more competitive
- A sharp rise in FDI both short and long term into all types of Japanese assets
- Many Japanese exporters have come to terms with the strong yen over the last 10 years by expanding overseas. The net effect of this yen weakness will reverse the trend and cause more Japanese companies to reinvest in Japanese operations and manufacturing
- BOJ will start to raise interest rates, which will be a good thing really all around
- Exporters in same competitive categories in other countries could see a temporary sell down in their shares


p/s photos: Olivia Ong

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