Junk yen

One of the great mysteries of financial markets is the intrinsic value of the yen. Of course this mystery is applicable now, after the outbreak of QE has become “epidemic”, to the value of virtually all of the relevant fiat currencies. For similar reasons, the value of the US dollar is increasingly becoming suspect. The euro is hardly a currency, and up to now it has been a costly experiment for all involved, except the core.

We will comment on the EURUSD in future posts. But let me say for now, that political commitment (and the political capital already invested) can delay the result for the euro, but sound economics always generates the road map. A currency is really a claim on an economy, “vía” the balance sheet of a central bank. As a medium of value and exchange it cannot be delinked from the underlying economy. There cannot be one claim on multiple economies, unless the currency is used in a way that some of them subordinate to others. Can subordination to German policy be sustained in the long run? Without major adjustments, the Euro is not a viable currency. For Europe it´s either full integration, or disintegration, or splitting the currency in at least two.

Back to Fiat currencies and the Yen. The end of Bretton Woods, was “the end” of solid currencies, and the beginning of a truly fiat currency regime. The minute that central banks were independent, and could dimension their balance sheet at will, the value of the currency in their books became, to say the least, unclear. With the gold standard gone, the value of the currency became correlated only with the quantity and quality of the assets in the books of the central bank, and more indirectly, but finally, with the value of the underlying economy.

I will not try to outline the basic arguments for a defense of the gold standard. My personal view on gold is not very “Austrian”, and comes paradoxically close to that of Warren Buffet or even Ben Bernanke (what a shame). I do not see gold as a reserve of value, nor do I think there is any reliable method to gauge the value of the metal. Price predictions for the metal are a joke, particularly with all the central bankers forming an explicit cartel, with the aim of controlling its supply in free markets. Indian or Chinese demand, together with panic or risk aversion buying, have become the other relevant factors in its pricing. All in all, pricing gold has become a particularly futile intellectual exercise.

Putting your assets in gold is no safer than doing it in corn, oil or the S&P 500. It may be more practical, but that’s all. The correlation of gold and the concept of “store of value” is a legacy of the old times. I simply cannot come with a solid reasoning on why it should be of preference to titanium or platinum, to name two other metals. Further, I do not think there is a single commodity, or financial product of any kind, than can be used as a standard of value.

We do need to anchor the balance sheet of the central banks and the size of the underlying economy (well measured), is the only viable alternative. But if we link the central bank balance sheet with the country GDP, with some laxitude to play the short term cycle, a lot of central bankers would be out of a job. ¡And no more financial bubbles, at least of the current size! How boring. It is really going to be the end of this story though. Just give history some time to play out.

But, in the meantime, we are where we are, and reality bites. When currencies are left without a standard of value, the experience tends to end badly. Gold is gone, and we have not yet found a substitute. History says, sooner or later the doves take control of the central bank´s balance sheet, or engage in currency (beggar thy neighbor) wars. The reasoning is ever so simple: being a dove you exchange good short term macro policies, for unintended perverse long term consequences. A dovish policy sticker is a win-win proposition when trying to be nominated. Paul Volcker was the exception, but his nomination has to be understood in a period (end of the seventies) when inflation was way out of control. Discipline is required at central bank committees even more than at a teenager school. In the long run, no discipline equals monetary debasement.

The junk yen is a case in point. Being the first country to encounter the difficulties of surviving a major credit expansion originated bubble, back in 1990, it has suffered significant market revaluations and devaluations (with some central bank interventions on the way) ever since.  After Abenomics, and a QE program equivalent to a monetary base expansion of 9% of GDP annually, it deserves junk status, yet it is still the darling of “risk off” portfolios.

To make things simple, you can look at a currencies value, in three ways. Let´s do it with the yen.

First, because it is the most direct effect on a currency, you have to look at the central bank balance sheet, and the rate of interest throughout the curve. The higher the rate the more attractive the currency is, all other things being equal. The smaller the balance sheet and the safer the assets, the more valuable the currency is.

Let’s go throug this for the yen. The central bank is increasing the balance sheet at an annual rate of 9% of GDP, and investing the money in mostly long term government bonds. If you look at the quantity side, obviously the value of the currency is being eroded. But things get even more interesting if you look at the quality of the assets it is buying: public bonds. With a public debt of over 240% of GDP, at a financial cost of 25% of government income, even at the actual ridiculous interest rate levels, the JPY and/or the Japanese long bond, are, as Kyle Bass puts it, “an accident waiting to happen”.

Some will come and say; the market does not validate this line. The long bond is trading for a yield of roughly 0,60%, and it is very stable. ¿What market? 90% of all JPY public bonds are traded against the Bank of Japan (BOJ). During two days over the last month, the central bank decided not to intervene in the market, and the result was zero transactions. Zero transactions!!!!! Is that a reliable market against which to price the bonds and work on the VAR in portfolios?

Look at this from another perspective. Abenomics is targeting 2% inflation and is already more than halfway there. ¿Is a curve stretching from 0,05% to 1,76% yield for the forty year bond sustainable? Not short term, but forty years out the curve? Are the bond prices supporting those yields, real market prices? How long can the BOJ keep this show up and running?

Second, when analyzing a currency, you want to take a look at the flow of funds and, as of late, you want to check the levels of all kinds of debt. After all, supply and demand form a price, and they are seriously affected by trade balance and capital  flows. Trade balance has turned around for Japan For 2013,  they logged a record annual trade gap of 11.47 trillion yen, widening from 6.94 trillion yen in the previous year and marking a third straight year of deficit. The current account still saved the day for the traditional save haven currency, but barely. For 2013, Japan’s current account recorded a meager 3.3 trillion yen surplus, the data showed. This was the smallest surplus in comparable data available since 1985. You can point your finger at energy, but these figures are an inevitable concern considering the nations huge debt.

Debt wise, Japan is still a net creditor of the world, so foreign investment can always be repatriated to repay debt. That is the official mantra to justify the financial prevalence of the nation. Maybe, but it does not look like the best time to boast an inflated country consolidated balance sheet, with substantial external assets, but with huge domestic liabilities to be considered. Selling external positions to deflate the consolidated balance sheet looks like a “must do”, on top of the need to adjust public debt figures to a sustainable level.

Third, it pays to take a look at the economy and its sustainable rate of growth, in view of the industrial infrastructure, institutional stability, educational level, population perspectives, productivity growth potential, etc. No good news either for Japan on this front. Its business model, based on exports is increasingly less viable in a context of currency wars and weak global aggregate demand. Its relationships with the main prospective importer for the next few years (China) are desperate. Energy dependence is as bad as it gets. Population is stagnant and aging. The US clearly won the high tech battle (just look at Sony). Want more?

Japan is the perfect example of a very unstable economic situation. Abenomics is still a fashionable experiment, but the outlook is not good. Long bond rates and JPY stability look like major financial risks, both for Japan and for the rest of the developed world. For financial analysts, Japan is a canary in the coal mine. The world has to believe the 100 USD trillion global debt pile is sustainable, and Japans solvency is central to that achievement. That, together with the Chinese credit and real estate bubble soft landing, and the stability of France Italy and Spain within the euro economy.

Implementing a financial strategy on the Japanese macro fundamentals, is tough. On one side, you have the traditional widow maker trade: shorting the Japanese ten year bond. Somebody will finally get the timing right, but the odds are all against you because there is no reliable way to try to time this. If you look at the currency side of the junk yen fundamentals, JPY shorts had a party a couple of months ago. Any further devaluation will be met with fierce opposition by the other countries and currencies involved. ¿For how long? Some investment advisors recommend buying some distant maturity, out of the money, call options on the USDJPY, at 120 or more. It looks like a very long term bet to me, but downside (option premium) is not substantial unless you go for huge volume. Certainly, a lot of things could go wrong before that. Not because the JPY might not be a “strong sell” recommendation, but because it is difficult to find a reliable fiat currency to short against. And the reliable ones are very well protected from market rates by their central banks. CHF looks like an alternative candidate. How long can the SNB hold on to the actual situation?

Nothing comes easy in financial markets these days. When prices are way out of line with fundamentals, find the central bank. You can´t see him, but you can bet he´s there. There’s hidden POMOS all over the place. It´s not that markets are efficient “per se”, but huge inefficiencies have to be patronized by a biased central bank. Your options are; you play with their pricing, or you fight the fed (them). Not comfortable, unless you just play the game, and stick to trying to beat your benchmark. Thinking big will sure ruin the game for you.

Some comments on the new widow maker trade asap. ¿Caught short on the EURUSD? Don´t despair. Regardless of Keynes´s long run death prediction, we should see some material changes before year end. We should be able to live to see them.