Tuesday, December 3rd, 2013

Suddenly Japan

Two weeks ago we discussed some of the possible consequences of the Fed taper, but we deliberately dodged the issue of when this is likely to start. Today we will stick with this policy, even though we are going to discuss something which may well happen before the taper starts, but which is directly connected with it. Suddenly everyone is talking about the long Nikkei / short yen trade and we need to understand why.

We think the explanation can be found in a dilemma faced by US investors. The returns from US equities are now significantly and positively correlated with those of the US Treasury market. So too are the dollar-denominated returns of every other major equity region – apart from Japan. Correlations can change, but for US investors the most likely result of this relationship is that US equities will sell off shortly after Treasuries and that overseas equities will see some weakness as well, especially if there is a period of dollar strength. US investors need something else to buy.

Long Nikkei / short yen
Some of the equity weakness will affect the dollar returns out of Japan, but there is one important difference. Investors believe that (1) they can separate the currency and the equity market effects with much greater precision than elsewhere , and (2) that there will be an inverse and simultaneous relationship between the two of them. The key word is simultaneous. Nobody disputes the idea that a weak euro would be good for German exporters, but most investors would expect to wait for several months before this showed up in order books. In Japan the time-scale is likely to be different, partly because the currency manipulation is explicit and larger in relation to the size of the economy, and partly because we already have a worked example from last year.

December is a good time for Japan to intervene in the currency markets. The US and Europe suffer from restricted liquidity because of the holiday season and because it is the close of the financial year for many banks and investment institutions. By contrast, the end of the financial year in Japan is March and although there is one public holiday over the period, this is not an excuse for empty offices and seasonal over-indulgence.

Exporters upgraded
Our local currency model shows a significant improvement in the attractiveness of equities vs JGBs and has upgraded equities from Neutral to Overweight. In similar vein, our Japanese sector model has upgraded Technology (one the most export-sensitive sectors) from Neutral to Overweight and it has gone from 5th to 2nd in the rankings over the last four weeks.

This may turn out to be a false dawn if the BoJ refuses to act, but by the time it does it will be too late for many international investors to take a position. Whatever happens over the next few weeks, it is important to understand this not about the next stage of the reform programme, or the rate of inflation or any other economic variable in Japan. In advance of the Fed taper, a weak yen is attractive to US investors, as is a rise in the Nikkei.

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