Seven Observations about the Yen

1. The yen was the weakest of the major currencies in Q1, losing about 7.2% against the dollar. There was a clear shift in both speculative and portfolio flows. The net speculative position in the IMM futures shows a swing from near the largest long position in a decade to the largest net short position since the onset of the financial crisis. In terms of portfolio flows, Japanese investors have stepped up their purchases of foreign assets compared to a year ago, while foreign investors have been net sellers of Japanese stocks and bonds in the first 13 weeks of the year, but were net buyers in the same year ago period.

This does not include the fact in the last week in March, foreign investors sold JPY3.48 trillion worth of Japanese bills, which is the most since the time series began in 2005. The sale of the bills could be related to other financial transactions, but it also may be a capitulation of yen bulls at the end of Q1. At times, fixed income managers who may be barred from taking naked currency position, express a bullish yen view through buying Japanese bills.

2. The less dovish FOMC minutes prompting a reassessment of the likelihood of QE3 may have triggered a pop higher in US yields and some thought that would weigh on the yen. However, the combination of the losses in the equity market and the heightened tensions in Europe has seen US interest rates ease. The premium the US offers over Japan at both the 2-year and 10-year sectors is less than it was a couple of days ago.

3. The Tankan Survey was disappointing in terms of sentiment of the large manufacturers and their capital expenditure plans. Nevertheless, the large manufacturers are looking for a stronger yen. They expect the dollar-yen to average JPY78.14 during the fiscal year that just began compared with JPY79.02 expectation in the December '11 survey.

4. As the dollar appreciated against the yen in Q1, volatility trended higher. Three month vol rose from 8% on Feb 14, when the BOJ surprised the market by expanding its asset purchases and providing a formal inflation target (1%) to 11.3% a month later. As the dollar's gains have been pared, volatility is stabilizing between 10.25%-11%. Volatility will likely come off further if the dollar continues to see Q1 gains pared against the yen.

5. The LDP-controlled upper house of Japan's parliament rejected the government's nomination for the BOJ board. The ostensible reason for blocking Kono's candidacy was that he was not sufficiently dovish. The terms of two board members expired this week and next week's meeting (Apr 9-10) will be held with 7 rather than the normal 9. Pressure is mounting on the BOJ to take more action. The March Tokyo CPI deflation has retained its grip, the monetary base contracted for the first time in a couple of years, and industrial production (Feb) contracted, contrary to expectations. BOJ Governor Shirakawa promised "powerful easing until 1% inflation was insight. Because the BOJ has barely begun the JPY10 trillion asset purchase plan announced in mid-Feb, some observers are looking at other actions the BOJ can take. Strengthening its loan facilities is one course that some are suggesting. That said, the markets will be disappointed if the BOJ does nothing next week.

6. The LDP rejection of Kono's candidacy also should be placed in the larger context of Japanese politics. PM Noda, the 6th prime minister in five years has seen his support rating halved since taking office in September. Countries have their own sacred cows. In the US, social security was regarded as the "third rail". In Italy, Monti has found that it is Article 18, which ossified the labor markets since the 1970s. In Japan it is the retail tax. Efforts to raise it has toppled previous governments, but Noda seems determined. It is splitting his party along old fissure lines (with Ozawa and his supporters balking at supporting the government) and the opposition LDP are more sympathetic, but want either to enter the government or new elections.

7. Barring aggressive action by the BOJ next week, we suspect external factors will be more important for the yen than purely domestic considerations. We are concerned that the best part of the liquidity induced easing of tensions in Europe is behind us and that political and economic headline risk in the weeks ahead are on the downside. This would likely support the yen against the dollar, but especially the crosses. The large under performance yen in the first three months is likely to be retraced. The risk is for the dollar to test the JPY80-81 area in the coming weeks. The euro can fall toward JPY104-JPY106. The relative high yen vol, rising vol in general (such as the VIX), and relatively narrow interest rate differentials suggest that the environment may not be conducive for carry trades (which entail using the yen as a funding currency). The technically-inspired tactical opportunities to short the yen that may exist from time to time should not be confused with carry trades, where the goal is "simply" securing the interest rate differentials.