Calling a Turn in the Yen

 | May 20, 2013 | 5:00 PM EDT  | Comments
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The yen's decline over the past six months has been nothing short of stunning, surprising even the most ardent bears. I admit that even I got this wrong when I voiced skepticism about the currency's decline in February. My point at the time was that monetary operations by the Bank of Japan -- quantitative easing, for example -- were not money-printing and therefore not bearish for the yen over the long term.

I've explained this many times, as well as how the public and many commentators get it wrong. A central bank can set interest rates by changing the composition of the financial assets held by the public. When it buys government bonds, that adds reserves to the banking system and this brings rates down. The public is left with fewer bonds and more reserves (cash), but no new financial assets have been created. In essence, no new money has been created, therefore, the currency effect is neutral. Moreover, the central bank does not "spend," which is the only way that new government fiat money can be created.

This was my main reason for not being bearish on the yen when everyone else was. If you look at the U.S. dollar's performance over the past five years -- we've seen umpteen iterations of QE and other measures by the Federal Reserve to boost reserves from $800 billion to more than $3 trillion currently -- the dollar is actually up. Yes, there was selling each time the Fed said it was going to do something, but those losses ultimately reversed over time.

For the yen, one very important fundamental remained bearish for the currency and that was the fact that Japan's balance of payments had swung deeply negative in the past year or so. This was due to the shutdown of the country's nuclear reactors following the Fukushima earthquake. With the reactors down, oil imports soared and that created a sharp reversal in Japan's trade position. Japan has run trade surpluses forever, so the swing to big deficits was definitely weighing on the yen.

This may soon change, however. Tokyo Electric Power Co. has applied for permission to restart two of its nuclear reactors by July. If approved, the move would be a first step in bringing Japan's nuclear power generation back online and that would have a huge impact on Japan's balance of trade, taking it quite rapidly back toward surplus from its current deep deficit.

The yen is currently at three-year lows against the dollar and with the prospect of a nuclear-power restart growing, we could be looking at the yen bottoming soon in anticipation of a change in fundamentals. You may want to start looking at something like the CurrencyShares Japanese Yen Trust ETF (FXY), which has fallen more than 20% since December, in line with the yen's decline. The risk-reward on this looks particularly attractive now that we may be nearing a major change in the yen's outlook, which could come into play as early as this summer.

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