Opportunities at the End of a Multi-Year Trend

It is Golden Week in Japan, a week with a cluster of four national holidays that typically is a time of travel and vacation for nearly all Japanese workers.  The Ministry of Finance, however, didn’t get to spend a relaxing day on Monday, April 28, as speculators took advantage of thin market conditions to attack the yen and drive it to its weakest level against the dollar since April of 1990. 

I have been waiting and hoping for this sort of market action. Let me explain why.

It is typically a perfect set-up for a vicious reversal and a dramatic reversal in the yen’s performance.  Put simply, if things play out perfectly, we are close to the yen putting in a significant, multi-year low against the dollar.  Moreover, once this reversal comes, we will likely see significant yen strength on the crosses as well.  It is still a little early, but this huge reversal might not be far away.

With relatively small intervention by the authorities, who only sold modest amounts of dollars in the market, dollar/yen dropped precipitously from 160.20 to 154.50.  It was a powerful turnaround on the day, reversing within a few hours a five-yen rally in the dollar over the prior three days of trading.  The speculators had gotten all excited last week because the Bank of Japan had left interest rates unchanged after their meeting, and they took this decision as a green light to pile even more aggressively into their short yen exposures.  Their exposures were already large, but their recent trading increased their overall positions from large to huge.

I have maintained tiny, long-dated option exposures betting on the yen strengthening over the next year, and I felt the move up to 160.00 was an excellent opportunity to start increasing the bet.  In fact, I am hoping the market will retest the resolve of the Ministry of Finance once more by pushing dollar/yen up to roughly the 162.50 – 163.00 level.  If this happens, I expect that test to be even more aggressively rejected by the Japanese authorities, possibly with US participation, and then the long-term strengthening of the yen can begin in earnest.  

The Japanese are the largest foreign holders of US treasuries, with over $1.2 trillion of US government paper, and the US can ill-afford a financial crisis in Japan due to a collapsing currency.  Such a development could easily lead to panic selling of treasuries by the Japanese as they try to reverse the dollar’s rise and stabilize their currency.  Clearly, this would not be in the best interest of the US given the massive sales of treasuries which are needed to cover the US government’s enormous deficit spending.  

Aggressive selling of US treasuries by the Japanese would also lead to further problems in the commercial US real estate market, which is already feeling the heavy weight of multi-year highs in vacancies and foreclosures. The problems in commercial real estate are already severe due to the current high level of interest rates, and they might get a lot worse as there is more than $2 trillion in debt coming due over the next several years.  Refinancing this debt will be very challenging at the current levels of interest rates, but even higher rates would likely bring this problem to a crisis level.  

The residential real estate market in the US is also struggling with the current level of interest rates.  The high mortgage rates are severely impacting the affordability of houses for Americans, and current mortgage rates are further leading to a very limited inventory, as owners of homes who had previously locked in attractive rates on their mortgages are unwilling to sell their homes.  The purchase of a new home would force them to take on new mortgages with much higher costs, so fresh inventory will remain limited.  Any further rise in interest rates would worsen this situation.   

The combined challenge of financing the US debt and trying to forestall further problems in the real estate markets already provides a strong incentive for US authorities to take steps to avoid higher interest rates.  The potential negative impact of higher rates on the valuations of frothy equity markets is yet another reason that the US will do everything possible to forestall heavy selling pressure on US treasuries.  Putting these challenges in the context of a US election makes the situation all the more important.  Accordingly,  it is almost certain that the US would cooperate to stabilize the yen if Japan were to ask the US authorities to join them in a large-scale currency intervention.

We only get opportunities like this infrequently, as major cyclical highs and lows take years to play out.  In almost every instance, the major tops and bottoms are preceded by wild speculation and somewhat chaotic market conditions.  We had a similar opportunity in 1998, after the dollar had rallied from 80.00 yen/USD all the way up to 147.65.  The central banks intervened sporadically during the dollar’s rally just to smooth things out, but in August of 1998, the US and Japan intervened aggressively and sold dollars heavily.  Within two months. dollar/yen crashed down to 111.38, seriously wounding many speculators in the process.  Dropping over thirty-six yen in two months is a massive move in the currencies, and this is the sort of move that we might expect once the current buying is fully exhausted. 

That period in 1998 coincided with the collapse of Long-Term Capital Management after the Russian debt crisis, and the authorities were on full damage control.  They were worried about Japan’s financial stability, so the intervention was coordinated.  The dollar would have ultimately crashed even without the initial shove of the authorities, but they helped jump start the move.

Over the following several years the dollar traded more calmly before beginning another surge higher, reaching 135.00 in 2002 before again dropping thirty-six yen, albeit in a more methodical fashion over several years.  This period was marked by more “normal” trading, with levels of volatility in the currencies that were typical.  The sorts of moves we have had over the past few days are very unusual, and they normally only occur when bubbles are finally bursting.  The bubbles can be US-centric, or global, but their bursting almost always leads to massive shifts in capital flows.  This is important to bear in mind because it takes huge capital flows to drive long-term trends in the currencies.  The forex market is huge, trading many trillions a day, so it takes gigantic flows to propel a currency on a persistent trend.

One of the strange things about forex markets is that these huge flows tend to attract further flows as investors and corporate hedgers are forced to act to reduce unwanted exposure.  That is why I like to think of this market as being somewhat akin to a huge ship that typically takes a lot of energy to get started, but once it gets started with a full head of steam, it tends to stay in motion for a long time.

After the dollar’s huge decline in 1998, its next major sell-off coincided with the collapse of the Bear Stearns credit fund and the onset of the Great Financial Crisis in 2007.  During this period, dollar/yen dropped from 124.15 all the way to 75.95.  The financial markets were in a panic, and the Fed took drastic steps to try to save the financial system.  They dramatically lowered interest rates from 5.25% all the way to zero and pumped huge amounts of liquidity into the system.  During this period the yen firmly re-established its role as the ultimate safe-haven currency.  

These huge reversals nearly always follow a period of excessive speculative fervor, very much like the one we have had in the yen this year.  Moreover, the final surge in speculative position-taking usually involves a spike top or bottom when the speculative activity reaches a panic pitch, not unlike the moves that occurred last week and in early trading in Asia on Monday this week.  Markets, however, don’t typically just roll over and reverse well-established trends so easily, which is why I am thinking the market may try again to take out the 160.00 level and drive the dollar even further.  Markets often like to re-test the resolve of the authorities and determine whether the intervention was just a smoothing operation to calm things down, or whether it was a more serious effort to stop and ultimately reverse the recent trend.

Many longer-term investors look at the relative yields offered in 10-year government bonds when they put on their carry plays to earn the interest rate differential between the two countries.  For example, the current yield in 10-year US treasuries is 4.61%, and the yield in 10-year Canadian treasuries is 3.76%.  It is hardly a surprise, therefore, that investors have borrowing Canadian dollars to fund the purchase of US dollars in order to earn that interest rate differential, pushing dollar/cad higher in the process.  With Japan, the interest rate differential in favor of the US is even more appealing since the 10-year rate in Japan is around .93%.  That is a significant interest rate advantage which long term investors can earn by funding their purchase of US treasuries by borrowing in yen.  

Many speculators with a shorter-term time horizon focus on the relative short-term money market yields when they play the carry game.  When considering the short-term rates available in the money markets in Japan and the US, the interest rate differential is even more compelling.   Speculators earn a full 5% annual yield advantage given the current interest rates when they borrow in yen and lend in dollars to establish a long dollar/yen spot position.   That works well as long as the yen is stable, or better yet, weakening.  When the yen strengthens aggressively over a few days, however, that loss in the spot market can overwhelm the hoped-for yield pick-up that is earned slowly over the course of a year.  Put bluntly, carry plays can turn into losses very quickly once the yen reverses and starts to strengthen against the dollar.  This is the sort of move that creates a snowball effect which propels the yen ever higher.  The more the yen strengthens, the more the market needs to buy yen to cover its losses on the spot side.

For me, this is now the time to pay very close attention to the yen as I start to build up longer-term option plays to capture what I am anticipating will be a massive reversal in dollar/yen.  I have been very patient until now, adding to my position on Monday, but leaving room to aggressively increase the exposure once I am sure the yen’s weakening is done.  The yen crosses are also going to be worth playing, as the yen will likely be the absolute outperformer.  Do we need more aggressive intervention for this move to take place?  Absolutely not!  In fact, when markets are reversing multi-year trends, one excuse can be as good as another.  Often, the market participants will try to identify a “cause” for the reversal, but the reality is that when a market is set to reverse, it will do so with or without an objective “cause.”

This week will be filled with lots of data and lots of “noise.”  Next week I will address multiple markets and how I see them shaping up.  Until then, wishing you all the best of luck.

Andy Krieger