A Closer Look at the Japanese Yen

I have written for some weeks about my view that the yen was set to strengthen against both the dollar and against the other major currencies.  The market has finally started behaving as expected. Since November 14, the yen has strengthened more than seven yen against the dollar, with the dollar dropping sharply from 156.75 to 149.50, with nearly 90% of that move taking place in just the past week.  Moves of similar size occurred in the various yen crosses.

My feeling is that it is now time for the yen to take a breather, and I have accordingly flattened out my yen exposures.  Going forward, I am looking to reestablish my long yen exposures once the yen goes through a bit of a corrective cycle. I am not expecting much more than a three percent correction, as the overall trend should still be intact.  It is unfortunately a little premature to pick either the exact timing or price level to re-enter my long yen exposures as I am not sure whether this correction will be marked by an extended period of choppy price action or a short period of sharper price corrections.  Either way, there is almost certainly going to be another sharp yen appreciation once the correction is complete. My best guess right now is that this corrective cycle won’t last much longer than two weeks, but even if we miss the start of the next cycle of yen strengthening, the move will be large enough for all of us to benefit from it.  

There are a host of technical and fundamental reasons for the yen to strengthen significantly overall, but for now we should be patient and not rush our re-entry.  The Bank of Japan is likely to hike rates again in the near future, and the Fed will likely continue easing rates further despite a variety of warning signs that inflation is not easing nearly as smoothly as Jerome Powell would like us to believe.  This further narrowing of interest rate differentials will be yen supportive, as will the likely yen supportive rhetoric coming from the Trump administration once they take office.  Offsetting these positive yen influences will be some inflationary pressures, but I expect the positive yen influences to win out in the end.

A further factor that we need to bear in mind is that once the stock market begins its next corrective cycle – and all markets have corrections at one point or another -- long yen exposures will prove to be a wonderful hedge against equity market weakness.  The yen is a safe-haven currency, and the power and magnitude of its strengthening might be surprising once equities finally start an eight-to-ten percent correction.  The skew in equity index options is priced so severely in favor of downside moves that betting on a sharp downside correction via index put options is a very expensive proposition.  In fact, holding long yen positions is a far more effective hedge against a sharp downturn in equity indices.  Therefore, holding long yen positions will be a particularly sensible trade for people with long stock biases

As you can see in this chart, the recent yen rally has been fierce.  You can also see from this chart why I like to scale into positions, adding to the exposures over time. Unfortunately, I don’t know exactly when my anticipated moves will start.  This scaling process allows me to have a good average entry on my positions and generate excellent returns once the forecasted move finally develops.  As I have explained, I tend to be early on moves, so this is my way of not committing too heavily to an idea too soon.

There are a number of interesting developments occurring in the forex markets, and for sure, the forex markets are going to heat up considerably over the coming months and years. President-elect Trump is leaving no doubt in anyone’s mind that he is a firm believer that global economics is a zero-sum game in which the United States must prioritize its own gains regardless of the impact our gains will have on our trading partners.  Put more simply, the implementation of heavy tariffs will have many ripple effects through our economy, and the economies of our trading partners, so we need to prepare ourselves for some absolutely wild times. 

Trump’s recent promise to impose 25% tariffs on Mexico and Canada has resulted in some short-term reactions in the markets, but traders don’t actually believe these tariffs will be implemented.  Rather, they are behaving as if the threat of tariffs is more of a verbal posturing designed to gain some advantages in upcoming negotiations.  I am not so sure. Yes, the Mexican peso and Canadian dollar have weakened since the recent announcement, but they have been weakening for months.

In fact, as you can see below, the US dollar has been strengthening against the Canadian dollar for some years.  The past few months have seen a sharp acceleration in the pace of the Canadian dollar’s weakening, and I expect this trend to continue.  After Trump’s recent announcement, the Canadian dollar weakened all the way up to 1.4175 against the US dollar before settling back to the 1.4000 level as traders reassessed the likelihood of these threatened tariffs actually being implemented – and what the impact of the tariffs might be.  

Frankly, I think it is a mistake to think that Trump is just bluffing and posturing.  He truly believes that the US has been foolish in its foreign dealings for far too long, and he intends to play rough in order to take away many unfair trade advantages that the US has granted to many of its international trading partners.

This first chart below shows the performance of the US dollar against the Canadian dollar over recent weeks.

This next chart shows the outperformance of the US dollar against the Canadian dollar over the past few years.

Against the yen, the Canadian dollar has also had a very nice initial recovery, but it has much farther to go in the big picture.  At a minimum, it will likely head back towards the low-to-mid 90’s against the yen.  Eventually, I wouldn’t be surprised to see cad/jpy head all the way back to the mid-70’s level.  These are enormous moves by currency standards, which typically trade at only a fraction of the volatility level common in equities.  In any event, we should have a chance to earn some excellent profits by being patient with these trades.

In my next write-up, I am going to address the history of tariffs in America.  I think that many of you will be surprised to learn how important a role they have played.  In light of the likely policies of the incoming administration, it is important that we understand how tariffs might affect us going forward.

Let me provide a little preview for you.  Historically, tariffs in America have served several primary purposes – to protect domestic companies from foreign competition and to raise revenue for the government.  Tariffs were also used as a negotiating tool to try to force more balanced trading terms with foreign nations, but that has not always been so effective.  In fact, from the start of our nation in the late 18^th century until 1860, average tariffs increased from 20 percent to 60 percent before declining again to 20 percent.  Yes, that is right. Twenty percent as a base level for our tariffs has a very long historical precedent in our country.  From 1861 to 1933, the average tariffs increased to 50 percent and remained at that level for several decades. Tariffs were the greatest source of federal revenue until the implementation of the federal income tax after 1913. 

World War I led to a rethinking by most Americans of the future role of the United States in international affairs. The United States had severe regrets about its involvement in World War I, and the reaction of the American people to World War I was extreme.  Our nation’s disgust with the war led to a sharp withdrawal by America from international affairs. Immigration became heavily restricted, and America generally was reeling from its attempt to make the world safe for democracy. (Immigration from Asia was banned, and there were quotas set on the number of immigrants we would allow from Eastern and Southern Europe.) In fact, the ramifications of the United States’ disgust with its role in World War I was far-reaching. While America emerged as the world’s most powerful economic nation at this time, it also led to the implementation of a variety of harsh international economic policies, including punitive treaties and severe tariffs.  Yes, the US was heavily focused on an isolationist attitude after World War I.

The Republican Party was in power throughout the 1920s.  The Republicans offered the American public a “return to normalcy,” the idea that politics and life in general should return to how things were in the late 19th century.  The Republican Party was led by  many successful businesspeople like Andrew Mellon. Their beliefs can be summed up by President Coolidge’s famous phrase in 1925: “The chief business of the American people is business.” These business owners felt that the government should be run on business principles, efficiently and within set budgets.  They also believed that successful American businesses would benefit everyone as there would be more investment and job creation.

Republican policy focused on the idea of laissez faire.  The Republicans believed in leaving the economy to manage itself. According to this belief, business and industry could grow unchecked - free from rules and regulations that might limit growth. With few regulations, costs would be lower, and owners would be able to invest more into business development. There was also a strong belief in rugged individualism, with Republicans resisting the call to intervene too much in society’s problems. This was because they felt that government help would undermine an individual’s capacity to solve their own problems.

Although these leaders were strongly averse to government regulation and intervention in business practices, the Republicans were keen to protect domestic industry by placing high tariffs on imports from abroad. They introduced the Fordney-McCumber Tariff in 1922 and then followed up with the Smoot Hawley Tariff in 1930. These acts placed import duties on many goods entering the USA. As a result, foreign goods became more expensive.  This supported American manufacturers although it also limited US products from being sold in huge quantities overseas due to tariffs being implemented by other nations in response to ours.

The Fordney-McCumber Tariff made it very difficult for Europe to do business with the United States.  This tariff act authorized the President to raise tariff rates by up to 50%.  This tariff raised average duties on all imported goods by more than 15% in 1922, and by more than 36% in 1923.  Naturally, this made it more difficult for European nations to pay the heavy reparations due to the US from World War I.  Later, the Smoot Hawley tariff in 1930 made foreign trade even more challenging.  Despite the tariffs, the US economy surged during the 1920s, the so-called “roaring 20’s.” The tariffs did little damage to the US during that era, although the impact on Europe proved to be catastrophic. In fact, the US economy grew by more than 40% during the 1920s, and the US economy accounted for more than half of the global economy.

I am writing about these things because we are about to embark on an interesting journey, marked by tariffs and increased global trade tension. I will also write about the equity markets as we are fast approaching some critical levels that warrant special attention.  Until then, I wish you all the best of luck with your trading.