In June of 2007 the carry trade was booming in the currency markets. Japanese housewives collectively dubbed “Mrs. Watanabe” by the press were beating weathered bank traders from UBS and Deutsche Bank at their own game as they drove USDJPY in a relentless one way move to five year highs of 124.13. Meanwhile, Nikkei rallied above 18,000 – its best levels this decade – as export driven Japanese corporations enjoyed tremendous exchange rate advantages both in Europe and North America and booked their strongest profits in years.
[B]What a difference a few months make.[/B]
The collapse of the US housing sector created a massive credit crunch in global financial markets triggering wave upon wave of risk aversion resulting in massive unwinds of the carry trade. Although the Japanese financial institutions were relatively untouched by the losses in the Asset Backed market, the Nikkei nevertheless plunged as the yen rose, racking up bigger losses than even the Dow Jones Industrial Average…
Presently, with USDJPY now trading around 106.50, the Nikkei has declined to 13,000 or more 5000 points off the highs in June. Furthermore, Japanese economy has taken a serious turn for the worse. The latest Eco–Watchers survey, always the most sensitive leading measure of consumer demand, has fallen to a four year low of 36 – way below the 50 boom/bust line. GDP growth is forecast to flatline completely in Q4 of 2007. In short, only a few months after seemingly ending its decade long struggle with deflation and contraction, the Japanese economy threatens to slip right back into economic malaise and the primary reason for its woes is the resurgence of the yen.
[B]Squeezed from 2 Sides[/B]
Economic growth is Japan is driven by corporate profits and capital investment. The consumer, hampered by stagnant wages and structural changes in labor laws that have favored temporary rather permanent employment, has been moribund for years. BoJ attempts to re-liquefy the system have done little to spur spending because growth in discretionary income has been practically non-existent for the average Japanese consumer during this decade. Therefore, it is the exports of Japan’s multi-national corporations that are the primary driver of economic growth in the land of the rising sun. Given that dynamic the exchange value of the yen plays a crucial role in determining the success or failure of the whole economy. According to the latest Tankan survey most Japanese corporations forecast the value of USDJPY in 2008 to be at around 113.00. With the pair now trading at 106.50 those hedges are deep in the red indicating that profit margins for exporters will suffer.
In fact, in 2008 Japanese multi-nationals may be squeezed from both sides as the high value of the yen and the global economic slowdown could prove to be a deadly combination as it raises costs while limiting sales. Already in the month January Toyota, Honda and Nissan experienced year over year declines in sales of as much 7% as the industry steels itself for its worst year since 1998.
[B]Intervention and Its Effectiveness [/B]
Therefore, given the sharp drop in the Nikkei, the virtual standstill in economic activity and the growing squeeze on its export sector, is not unreasonable to wonder if Bank of Japan may begin to intervene in the currency market to help prop up USDJPY? Latest anecdotal evidence suggests that Japanese corporations have adjusted their budgets to accommodate 100-105 USDJPY exchange rates for this year. That means that the BOJ may not tolerate any drop below 100 level in order to assure that the country’s exporters are not crippled by uncompetitive exchange rates.
While the effectiveness of currency intervention as a policy tool has been an ongoing debate within the financial markets and academia for years, there is little argument that at least in the short tern it can brutally effective. Amongst the G-3 central banks, the BOJ is by far the most active practitioner of this policy. Furthermore, the BOJ like to optimize the effectiveness of its intervention by fading speculative extremes. According to COT data speculative positioning is actually very long yen at the moment with speculators registering 98% reading on our proprietary 52 week gauge.
[B]What Does this Mean to Traders?
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The possibility of BOJ intervention can have radically different implications for currency traders depending on whether they are trading momentum or carry strategies. Let take a look at each idea separately.
[B]Momentum Traders[/B]
Momentum traders looking to sell a break of the 105.00 level should be particularly careful with their size and their stops. If BOJ does decide to intervene, the counter trend moves that develop in the wake of this policy tend to be highly volatile with USDJPY often rising more than 100 points within minutes of the action. These moves are designed to be exacerbated by the skew in positioning which catches the majority of the specs of guard and forces a massive short covering rally in the pair that can magnify losses even further. Therefore, those traders betting on a break should trade with smaller size and predetermined stops so that if they do run into a wall of intervention they would be able to absorb the risk with minimum of pain.
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Carry Traders[/B]
Carry traders, looking to pick up USDJPY longs at value levels should employ a different strategy by scaling into their positions with BOJ essentially acting as their back stop. Intervention is typically not a one time affair for the BOJ. Once Japanese monetary authorities’ decide to defend a price level, they will employ their resources over and over to make their message clear to the market. As the following table shows, the most recent rounds of BOJ intervention lasted for several months. This means that even if the 105 level is broken USDJPY is unlikely to fall to 100 right away as BOJ makes constant forays into the market to prop up the pair. Therefore, those traders positioned long the carry should look to stagger their entries and stretch their stops to take advantage of the larger, more fluid price range that may develop, betting that at least in the short term the bid of the BOJ will support their long USD JPY positions.
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[B]Conclusion[/B]
While there is certainly no guarantee that the BOJ will intervene at the 105-100 area, economic factors and positioning data suggest that Governor Fukui and company may indeed opt for that solution. Given that possibility the above mentioned strategies should hopefully minimize risk and optimize return for both momentum and carry traders. At the very least traders should pay particular attention to the price action if USDJPY slides down to the 105 level in the near future.