More Thinking About the Japan and the Yen

The Bank of Japan announced a new liquidity facility today of roughly JPY10 trillion in three month loans to commercial banks. The BOJ came under pressure from the DPJ government and BOJ Governor Shirakawa can be forgiven if he does not see much of a difference between the pressure brought to bear by the previous LDP government and the new DPJ administration. Shirakawa was clear that although he conceded that this measure be considered as a quantitative easing, a phrase he has generally avoided using, there was not change in the BOJ's economic assessment. The measure today was meant to address what Shirakawa says was potential adverse effects on corporate sentiment caused by the rising yen and weaker share prices.

The market, and perhaps the government, was looking for bolder action when the emergency BOJ meeting was first announced. The bulk of the pullback in the yen appeared to take place prior to the outcome of the BOJ meeting. The market has been underwhelmed.

Three-month yen rates did ease a few basis points, but three-month dollar Libor was still fixed below the three-month yen Libor. Three-six month dollar Libor (fix) is below the yen Libor, though the rest of the term structure, dollar rates are above yen rates.

There was though notable developments in volatility. Three-month implied volatility reached 15% on Nov 27 as the dollar fell through JPY85 for the first time since 1995. Earlier last week, Nov 24, the implied vol was just above 12%. Now it is bid near 13.6%.

The easing of volatility corresponds to the dollar generally holding above JPY86. The correlation between the yen and volatility is fairly consistent. Over the past month, the two have moved together about 48% of the time. Over the past three months, the correlation has been almost 50% and the year-to-date, there is a 48% correlation. In 2008, using daily data, the correlation was almost 55%. In the current context, volatility can ease provided the yen stays range bound. Given the proximity to JPY85 and levels not seen in a generation of market participants, look for volatility to rise in the dollar falls back through JPY86.

Another impact of the BOJ's decision has been on risk reversals. Recall that put-call parity means that puts and calls the same distance from the forward strike should trade for the same price and to the extent they don't, it reflects some bias in the market. That bias is what the risk-reversals measure.

Typically yen calls trade at a premium to yen puts. Option dealers explain this bias by noting demand for from Japanese corporates repatriating or protecting revenues related to foreign sales. As recently as Nov 24, the 3-month yen calls (25 delta) were selling at a 1.5% premium over yen puts. When the yen spiked higher at the end of last week, the premium rose to 3%, which corresponds to the 200 day moving average. The premium for yen calls slipped a 0.25 percentage points yesterday and 0.50 percentage points today. At around 2.25% the premium is still relatively wide. A short period of range trading will also likely see the premium for yen calls narrow a bit more.

Today's BOJ announcement, however, does not appear sufficient to stem the tide. Officials continue to seem reluctant to intervene, though the CFTC Commitment of Traders and indicative pricing of the risk-reversals shows a terribly one-way market. The mini-short squeeze that failed to lift the dollar to its old floor near JPY88 warns that the one-way market bias has not been broken.

Today's operation is very similar to the one adopted a year ago at the conclusion of another emergency BOJ meeting. Then there was no cap on the program compared to JPY10 trillion now. After a short lived rally in response to the early Dec 2008 move, the dollar slipped lower to record a new low toward the middle of the month near JPY87.15. The next regularly scheduled BOJ meeting is Dec 17 and 18th. At the mid-Dec meeting in 2008, the BOJ stepped up its purchases of JGBS from JPY1.2 trillion a month to JPY1.4 trillion. Those purchases stands at JPY1.8 trillion now. At least some government officials would like the BOJ to increase this kind of operation.

The key take away points are : 1) the new liquidity provision has not driven short-term yen rates sharply lower; 2) yen longs have not been put in sufficient pain to force them to liquidate; 3) Japanese officials appear reluctant to intervene; 4) near-term range trading is the most likely scenario and the risk is that this is followed by new yen strength.