The Optionality in Shorting the Yen

Recently we’ve initiated a short position in Japanese Yen in our Fixed Income Strategy. Some observers have been forecasting economic catastrophe for Japan and its currency for many years based on its poor demographics and steadily worsening fiscal situation. Kyle Bass is one of the better known Japan bears, and he has written eloquently about the problems he foresees. Timing has been frustrating the Japan bears for years, in fact for decades, in spite of the compelling case that Kyle Bass and others like him make. Shorting Japanese Government Bonds (JGBs) is not a new idea.

So it is with a healthy respect for the unsatisfying history of such investments that we are cautiously venturing into this area. What makes this an interesting opportunity today is the presence of some optionality around events which could weaken the Yen.

Japan’s trade situation has been worsening in recent months. For decades Japan has been a huge net exporter and has consequently amassed hundreds of billions in foreign assets. But in August the country experienced another steep fall in exports, the 18th consecutive month of deficit (seasonally adjusted) following the earthquake and tsunami of last year. Japan’s phase-out of nuclear power and increasing reliance on imported natural gas and crude oil represent a structural shift in its trade flows. The source of Japan’s historic capital surplus from its trade sector is beginning to reverse.

While Japan is suffering from lower exports to the EU, it’s worth noting that China is Japan’s biggest trading partner. Any slowdown in Chinese growth will have a disproportionate impact on Japan’s economy. The ongoing dispute over the Senkaku islands (Japanese name) or the Diaoyu (China’s) will most likely amount to nothing as far as investors are concerned, but there’s always the chance that a miscalculation on either side could lead to something more serious. One might imagine that a dispute with its biggest trading partner would hurt the Yen, although historically Japanese investors have reacted to trouble at home by repatriating assets and driving the value of the Yen up, so this is a bit of a wild card.

More tangibly, growth differentials continue to favor the U.S., with Japan’s economy likely to experience only around 0.5% real GDP growth in 2013, down from 2% this year. Japan is also facing its own version of a fiscal cliff and last week the BOJ announced it would increase its version of QE from 70TN Yen to 80TN to offset the likely GDP headwinds from the legislature’s failure so far to pass a budget.

All these issues represent some optionality, in that they may be resolved without consequence but also create the potential for downward pressure on the Yen. Promoting a strong currency seems to be a quaint notion nowadays for developed countries, as the Fed, ECB and BOJ all engage in the “race to the bottom” in order to try to stimulate growth through stronger exports. Japan is as well equipped as any to weaken its currency.

Finally, the US$/Yen exchange rate hasn’t been that interesting lately. After running up to 83 and back during the Summer it’s been directionless and is not far above the lowest levels in many years. A 5% drop in the US$/Yen exchange rate from here would be substantial, and doesn’t seem that likely. It may do nothing but there are plenty of catalysts that could drive the exchange rate higher (i.e. weaker Yen) and the longer term outlook for the currency is negative.

We are long the ProShares Ultra Short Yen (YCS) as a way to express this view.