Japan to Report Another Trade Deficit

Early Thursday in Tokyo, Japan is likely to report a trade deficit for February. On a unadjusted basis, it will be the 5th monthly deficit. Based on the trade figures for the first twenty days of February, it will likely be the smallest of the streak. The consensus is for JPY120 bln shortfall. On a seasonally adjusted shortfall, will the eleventh in a row. At the consensus guesstimate of a JPY342.5 bln deficit, it will be the smallest since September.

Exports are still falling on a year-over-year basis, but at a slower pace. Imports are still rising, but here too the pace is slowing. The swing into trade deficit for Japan happened from both sides. Exports were squeezed by the strengthening of the yen and weaker foreign demand. Imports were bolstered by energy imports as its reliance has dramatically risen since last year's tragedy.

Still, the January record trade deficit (JPY1.48 trillion) and the anticipated recovery in February was distorted by the Lunar New Year, which shuts down many Asian centers, most importantly, Japan's biggest trading partner China. Nevertheless, if the trade deficit comes in near consensus, it will likely be sufficient to see broader current account measure swing back into surplus for the first time since Feb 2011.

The key driver for the current account is not the trade balance, which is so yesterday, but the investment income. This consists of items like dividends, coupon payments received, licensing fees, and royalties. It is fairly stable. Over the past six months, Japan has received an average of JPY1.11 trillion a month. The monthly average over the past year is JPY1.17 trillion.

We have argued that in the past, the yen appreciated when Japanese investors were unable or unwilling to recycle its trade surplus. Now the challenge is recycling its capital inflows.

Part of the reason the yen is weakening is that speculators, judging from the IMM Commitment of Traders, have reversed out of a net long into a net short position of roughly the same size. Portfolio flows have also changed.

Drawing on the weekly MOF time series, foreign investors this year have reduced their average weekly purchases of Japanese stocks and bonds to JPY138 bln compared with JPY314 for the same 2011 period. While foreign investors have cut their yen purchases, Japanese investors have increased their yen sales for foreign assets. Japanese investors have more than doubled their weekly purchases of foreign assets from JPY230 bln a year ago to JPY522 bln now.

Support of the dollar against the yen has also been the widening of the 2-year interest rate differential. The gap, which the BOJ Governor has also identified as highly correlated with the dollar-yen exchange rate stands near its widest level since last July.

In addition, as we noted previously, in an unprecedented fashion, yen puts are being trading at a premium over yen calls (25 delta risk reversals). Bloomberg data goes back to Q4 2003 and as we noted back in January when it first took place, this has not happened before. Historically, yen calls trade at a premium to yen puts as Japanese exporters and investors use options market to hedge their dollar receivables through the options market. This unprecedented shift in options pricing anticipated the reversal of the yen and may reflect the more consistent trade deficit in the recent period.

That said the near-term outlook for the yen may be more constructive. Speculators at the IMM have established among their largest short yen position in recent years. Over the last 4-5 sessions the market has tried pushing the greenback above JPY84 and failed to established a beachhead. Momentum and other technical indicators warn the market is stretched, after the dollar has rallied more than 10% against the yen since the end of January. A break of the JPY83.00 area is needed to confirm a top is in place.