One-Way Yen Trade Won't Continue

 | Feb 19, 2013 | 2:00 PM EST  | Comments
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The early statements out of the G7 last week contained lots of talk about currency manipulation. The yen initially took off when it was believed that the big industrial nations would not tolerate policies leading to any sort of competitive devaluation scenario. But the rally proved to be short-lived after a "clarification" seemingly aimed at giving Japan a pass on its weak yen policy. The way it sounded, the Abe administration has basically been accorded a green light to pursue further yen weakness.

Curiously, the pronouncement appears to conflict with statements made back on Feb. 8 by Japan Finance Minister Taro Aso, who said that the yen had weakened more than intended. The comment may have been a signal at the time to halt to any further yen sales by the country's large life insurers. The connection between Japan's Finance Ministry and the investment policies of Japan's large financial institutions are well known.

Short-term speculative selling by funds can only drive the yen down so far. You need to have the life insurers in there to sustain any move as they have tremendously deep pockets by virtue of the fact that they hold trillions in yen deposits. But even that can only weaken the yen to a point. To permanently weaken the yen you need yen "printing" and only the government can do that with sustained deficit spending.

Most people assume that it's the central bank, via monetary operations, that does the yen printing. If this were true, then the yen would have been falling for the past 15 years because the Bank of Japan has been conducting numerous episodes of quantitative easing over that time.

Quantitative easing or any monetary operation conducted by a central bank, whether that is the Bank of Japan, the Fed, the ECB the Bank of England, merely changes the composition of the financial assets held by the public. It doesn't add any net new monetary assets. On the other hand, deficit spending by the sovereign government, like the government of Japan, does.

The problem is that Japan's deficit is expected to shrink this year. That may come as a surprise given the record budget that has been proposed, but higher taxes and a stronger economy could bring the deficit well below the ¥23 trillion forecast. In fiscal year 2012 Japan had a ¥24 trillion deficit.

Of course there is always the matter of Japan's growing current account deficit. This has largely come about as a result of higher oil imports due to the shutdown of the nation's nuclear reactors. Initially there was some hope that Shinzo Abe's election would hasten the restart of the country's nukes, but those hopes appear dashed thanks to some very stringent new safety measures that will need to be implemented prior to any restart. According to some, it could mean Japan's reactors won't be back in operation for several years. In other words, Japan's oil imports and its current account deficits will persist.

Clearly some forces do appear to be aligned against the yen, but a continuation of its one-way decline is doubtful. Just as an aside, the recent reports of big gains by U.S. hedge funds who were short the yen make it even less likely that those big gains will continue. Remember what happened to the big gains by hedgies in Apple (AAPL) shares? I rest my case.

Bottom line, look for yen trade to become more two-sided in the months to come. For trend followers that may mean a long period of giving back a good part of those winnings. But for traders who like to buy low, sell high and repeat, the situation is starting to look a lot more promising.

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