Some Initial Thoughts on Currencies

While not much has happened in recent months to warrant changes to the portfolio, the single most interesting thing has been the march of the Yen.  As this graph shows, the yen has continued to strengthen (a drop in the graph = yen strength, and dollar weakness) fairly steadily throughout the period and this has also been broadly true since mid-2007. 

As you can see the big spike in mid-September was when the Bank of Japan announced it would intervene to slow the yen’s rise (during September it bought sold 2.12trn yen and bought $25.4bn).  The alert amongst you will have noticed that September’s intervention wasn’t sterilized (i.e. the Japanese just printed the money and then bought dollars with it) as Japan again tries to create inflation.

With the yen having started rising again, we have unsurprisingly seen the Bank of Japan moving to employ new ways of trying to prevent the yen’s rise, including asset purchases of corporate bonds, real estate trusts and even stock funds!

But, why’s this interesting?
Well, because Japan’s government bonds have (again) become a popular theme on the short side with Kyle Bass, amongst others, eloquently stating the case (here on CNBC).  A corollary to this is the generally held view that the yen should be far weaker, with various Japanese politicians (not to mention various financial folk) others suggesting a 120 Yen/Dollar rate as being ‘fair’.  Over time, I have great faith that both those who are short the yen and JGBs will be proven correct.  I can’t help but wonder, however, if in order to see the yen move to the 120-140 range that people predict, we won’t have to see it reach the other extreme (i.e. the Yen at 50-60) first! 

Perhaps, the move that’s currently underway is the start of a spring uncoiling, after all Japan’s consistent trade surpluses (and the foreign reserves that they’ve build up) mean that the Japanese (like everyone else) are short the yen.  If people start to unwind those positions and the stronger Yen causes Japanese exporters to struggle (and potentially need to take on more debt…thus increasing the demand for yen) then things could get really interesting.  The irony is, of course, that if the Japanese government is successful with the asset purchases and even manages to create inflation, the victory will be pyrrhic (as the higher inflation will necessitate higher nominal interest rates on JGBs, hastening the default that the JGB shorts see coming).

So that’s my ponderings on the yen, interesting but given the scope of the move the risk-reward probabilities suggest that there’s nothing to do here,  However, as mentioned back in the mid-year review, one of the things I have my eyes on is a short position in the Euro (vs. the Dollar)…something that’s not a popular sentiment these days.

The dollar has been unquestionably weak against the Euro over recent months (see this chart).  It’s also expected to remain weak for the foreseeable future, with Europe countries having seemingly resolved their sovereign debt problems and the Fed poised to undertake another Quantitative Easing program (QE2).  However, with a 10% move over the last month and sentiment so anti-dollar, is all the news priced in?

Certainly, it seems pretty certain that QE is coming after the Fed’s Nov 2-3 meeting with people now mainly arguing over the size (will it be $1trn at once in a shock and awe move, or $100bn a month for 6-12months?) and the instruments that will be purchased (predominantly Treasuries, but potentially also some munis).  For those who’re wondering why the QE is seen as such a sure thing; through Bernanke’s statements (and those of his cohorts, like Charles Evans), it’s become clear that there seems to be consensus for it.  The only thing that the Fed fears more than inflation is deflation; and if a picture’s worth a 1,000 words, then the Fed’s fears can be summed up in this one chart (source: SF Fed):

As for Europe, are the sovereign problems are resolved (with Portugal, Ireland, Italy Greece and Spain now model sovereigns with no real probability of default) or has the ECB’s program to back-stop the debt provided suitable liquidity to push the questions of solvency further down the road.  I would suggest that a real solution to the problem of excess debt is unlikely to be found in taking on more debt, and programs that facilitate this rather than looking for a better long-term solution are likely to eventually fail.  While the ECB’s moves have succeeded in pushing the spectre of European sovereign failures from the front pages, they haven’t addressed the underlying problem (too much debt!).  Furthermore, I would expect that any recurrence of the fears that we saw earlier in the year will be reflected in the Euro’s performance.

Longer-term, as readers know, I believe that the problem of excess credit/debt will be solved either by paying back the debt or by defaulting on it (and the creditor having to write-off that debt).  When you payback debt (and don’t replace it with new debt) or write it off then dollars are removed from the system…and the dollar, like all things that become scarcer, will go up!  While the scale of the Fed’s QE is expected to be large ($1trn), it pales in comparison when we consider that about 50% of the world’s debt issued is denominated in dollars.  As such, there’s likely to be a meaningful opportunity to go Long the Dollar (vs. the Euro) in the near future.