Yen Update

The Japanese economy is recovering from disruption of the earthquake/tsunami. Supply chains have mostly been re-established. The economic contraction is likely to end this quarter. However, the yen strength is not a function of the domestic economic performance. Yet market participants seem to intuitively understand the yen's strength more than the euro's resilience.

The yen is a safe haven, after all. That assertion seems so obvious, that why it is the case is rarely explored. It does not seem to be a function, as some suggest, of its trade surplus, but rather its position as a net international investment surplus country. That means that Japanese investors own more foreign assets than foreign investors own of Japanese assets. In fact, Japan is the world's largest creditor. Last year, it was in surplus by over $3 trillion. China is the world's second largest creditor at about $2.2 trillion and Germany is in third place with a $1.2 trillion surplus. Next are Saudi Arabia and Switzerland, both of which are net international investment creditors at a little more than half the size of Germany.

Of the world's top five creditors, only the yen and Swiss franc are "clean" plays. Two are pegged or not convertible (China and Saudi Arabia) and one (Germany) is part of a unified currency that is composed of weaker alloys than the German steel.

The safe haven status of the Swiss franc and Japanese yen is risking their domestic economic and financial objectives. The SNB has been more aggressive than the BOJ. The BOJ intervened once (so far) and increased the size of its asset purchases. The SNB has steadily moved to increase its sight deposits, buy back bills, and engage is currency swaps.

The SNB took first mover advantage and this may have helped spur the BOJ's record intervention the next day. However, the Japanese officials have limited their response in recent days to oral arguments (verbal intervention). However, the more successful Swiss officials are in breaking spirit of CHF bulls, the more pressure may mount on Japan and the yen.

There is another, though partly related source of pressure on the yen. It is coming from interest rate differentials. On August 4th, the BOJ Governor Shirakawa noted that there was a "relatively high correlation" between the spread between US and Japanese two-year interest rates. The two-year spread is near 3 bp currently, more or less the lowest it has been since 1992.

Japan used to be the low yield. The zero-bound policy rates brought other countries official rates more or less to Japanese rates. The risk of a new recession in the US and the Fed's promise to keep rates low through at least mid-2013 has seen the US rates take another leg down. However, Swiss moves have purposely driven there rates down. The Swiss 10-year bond yield is about 82 bp, 16 bp lower than Japanese yields. The Swiss 2-year yield is now near -16 bp.

Many real money investors cannot take naked currency exposures. What some appear to be doing to take advantage of the prospects for yen strength is to buy Japanese bills. The MOF data out earlier today showed foreign investors ploughed almost JPY3 trillion into Japanese bills in the most recent week. This is the most since at least Jan 05, when the time series began.

Net long speculative positions at the IMM also remain near the upper end of the multi-year range. There can be little doubt that long yen is a crowded trade, but if it has to take up some of the slack created by the more successful SNB, the yen can get stronger. 3-month (25 delta risk reversals) favor yen calls over puts by 2.5%, which is the near the largest premium in over a year.

It is difficult to have much confidence in support/demand for dollars against the yen below JPY76.25 its historic lows. However, a break of JPY76 may trigger a new wave of short covering by Mrs Watanabe and hedging by Japanese corporation. Based on current spot and volatility, JPY72.75 is 1 standard deviation from spot and about JPY69.25 is 2 standard deviations. These are cited to be suggestive of where the dollar can go from a simply quant point of view.