The End of the USD Depreciation: Part II

Over the past couple of days, I received a few calls and email from some of you asking about my Yen/USD trade idea that I mentioned in my previous post, for those of you that didn't get the quarterly publication, here was the FX trade strategy that I wrote up back in April:

First off, I will start with some history and fundamentals for those of you who aren’t active in the foreign exchange market. The popularity of the USD/JPY trade has come a long way. In the 1980s, during the Carter and Reagan era, the US was going though a time of high inflation and high interest rates and the Americans were unhappy with the strength of the USD (1 USD = 260 JPY) so during the Plaza Accords, James Baker and the Japanese government agreed to let the USD freefall against the JPY. The JPY settled at around 130 JPY/USD in 1990 and this let to huge strength for the Japanese economy. Along with deregulations in the Japanese financial industry and speculation of the housing market supported by the government, the real estate bubble exploded, banks that were “too big to fail” went under and it drove the Japanese economy into the lost decade (Doesn’t that sound similar to subprime 2008 huh?). This was when the original quantitative easing tool was first applied to fight the severe recession. For over two decades, Japanese’s bond yield hovered near 0% and therefore it was very popular for traders to build carry trades with the USD/JPY pair due to the carry from the interest rate differentials.

So, what is a carry trade?  In a carry trade, an investor borrows in a currency with low interest rates and re-invests in a currency with higher yield. But in 2010, due to the appreciation of the JPY (if you read my previous papers you would know why), which had a 15% gain versus the USD, those who pursued a yen based carry trade strategy suffered huge losses on their P&L. (Below is a table explaining the JPY based carry trade with the 2011 YTD return and the last 12 month’s return)

I mentioned to many of you that when the JPY broke 80 against the USD last week, the appreciation of the Japanese Yen is coming to an end, especially against the USD and EUR. Not long ago, the Japanese government intervened to depreciate the currency to support its economy, but as we all know, that didn’t last too long before the climb continued. However, this time around, it’s going to be different due to two main reasons:

1. Interest rate differentials from the inflation pressure at the FED and ECB
2. The reversal in trend of monetary base due to the recent earthquake.

Inflation: if we take a look at the global economic situation, central banks are facing growing pressure to tighten up monetary policy from the inflationary pressure. The CPI projection for 2011 in the US is at 2.7, the CPI for the Euro Zone is near 2.5 while the Japanese CPI is projected at 0.1. Not only is food inflation creating a problem, the expansion of balance sheets due to the recent financial crash are forcing the long term yields to rise. Rates are at their historical lows for the FED and the ECB and the market has already priced in for the Fed to shift 25 bps by Aug 12^th and the ECB to equally shift 25bps by April 11^th. Now, as the Japanese economy remains deflationary in 2010 and 2011 (FYI, Japan’s core CPI excluding energy and food fell 0.7% year over year in December 2010)  this earthquake will only force the BOJ to keep rates at this historical low to boost economic development. For those who are active in the F/X market, the two year US/Japan swap rate differential moved from the low of 9bps to 46bps today.

Monetary Base: interest rate differential and the Japanese/US Monetary base ratio are two main macro factors that explain the currency movement between the two countries. While the FED expanded its balance sheet to about 2.5$USD Trillion with the two QE programs, the purchases is expected to end in June and we will most likely see the Fed reversing its actions to reduce the monetary supply in the system. Before the earthquake, the ratio of the Japanese monetary base to the US settled at 51.8 at the end of 2010. After the earthquake, the BOJ decided to increase the size of its asset purchase program to 40 Trillion Yen and this will boost its monetary based by 5% while the Fed is expected to do the contrary in June. Based on a simulation done by Bloomberg, this will reverse the recent decline of the ratio from 45.1 in February 2011 to about 48.1 when the BOJ purchase will be completed. Last and not least, on March 18^th, the G7 central banks coordinated an effort to flood the Yen in the global market by injecting 15 Trillion yen to stop its appreciation (So for you smart ones, hope you figured that there is a floor here!).