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Positioning Yourself for Japan’s Potential Demise…

October 28th, 2009 Michael McDonough

-Strong domestic demand for Japanese government bonds has permitted Japan to keep interest rates at or near 0 despite significant increases to the government’s debt burden, with no significant currency depreciation, and almost no economic growth. But, this model may be coming to an end

-An aging Japanese population will have several negative effects on the economy: 1) Higher taxes to fund the country’s pay as you go social security system. 2) Retirees will begin drawing from savings to fund retirements. & 3) Reduced demand for JGB’s will force the government to seek capital outside of Japan, which should lead to a run-up in rates. Any increase in interest rates should have substantial effects on the government’s ability to finance it’s debt.

-The ‘illusion’ of the YEN being a ‘safe-haven’ currency could soon dissipate. Not to mention the aforementioned issues, the bulk of Japan’s economic growth–and decline–has stemmed from the export sector. A strengthening Yen against its trading partners will add further pressure to this sector, and place additional pressure on Japan’s growth going forward.

Take a short position on the Yen versus USD:

*Buy USD/JPY puts

*Short YEN against USD (ETF: YCS)

Open a position to take advantage of anticipated rise in Japanese rates:

*Buy call options on Japanese yields

**For a more detailed look into this topic please see my column posted on TheStreet.com’s RealMoney section.

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  1. Joe
    October 28th, 2009 at 14:55 | #1

    What you’re writing about has been a major thought pattern for a while now among a certain group of people. For example:

    http://online.barrons.com/article/SB125392834154042883.html

    Look him up, you’ll see him saying very similar things about China and Japan going a while back.

    My thoughts are closer to:

    http://www.ft.com/cms/s/0/fca464c0-9659-11de-84d1-00144feabdc0.html?nclick_check=1

    I think the major issue I have with this line of thinking is the following – basically, if Japan goes, so goes the United States. If Japan’s government is no longer able to roll over US debt; either China steps up huge or the whole system goes bust.

    It’s possible you are correct, certainly. On paper Japan should already have a major inflation problem, a major health crisis and a dire labor shortage.

    What is actually happening on the ground is nearly the exact reverse.

    You can argue that the JGBs are in a bubble (I tend to think so) that Japanese savings have gone into speculative Brazillian/South African/Indian/Australian/New Zealand bonds.

    You can go further and say that (high yield bonds) is where the Japanese inflation is: all of this I can accept.

    But consumer prices are falling at a record clip. Stock market (Nikkie 225) is at 10,000 a level it hasnt been at since the early 1980s. Property prices have barely budged upwards. Even the health care sector is under strict constraints by government pay masters.

    Besides short term government or near government (banks), where is the inflation?

    **Where is the economy straining due to lack of capacity?**

    While it’s hard for me to believe it as well, being in Japan, I really do think Japan is the classic case of a Keynesian recession/depression. Richard Koo is right this time.

    –in terms of trade–

    I think shorting the Yen is at the present a smart idea as too many Japanese businesses and individuals expect a stronger Yen to continue. Certainly, we are seeing the rest of the world markets go back to where they were last year, and the Yen was at least 10% weaker then.

    But this is very different from saying that it’s a smart bet over the longer term. While the JGB bubble has certainly popped in 2002-2003, the move in the other direction is (or more accurately, has been) an extremely slow one.

    My personal thought is that what’s expensive here are government bonds overall, regardless of nation (maybe India’s the exception?), and that within that relative context Japanese equity assets have been in a bear market for nearly 20 years (in terms of stocks) and 17 years in real estate: is it likely to go down for another 10 years? It seems more likely we are closer to the end than the beginning.

    I would rather short US Treasuries as the opportunity arises. While Japan still has an export engine that benefits from a weaker Yen, the US has an oversized health care, education and government sector that will drag it over the edge if ever the US Dollar really comes under world pressure.

    I dont see that happening soon as no one is seriously unhappy enough to end the relationship (despite not very well sourced rumblings to the contrary); but if you’re correct and Japan goes Argentina-lite, then they’ll be no choice.

    Look forward to reading your comments.

    Joe

  2. Joe
    October 28th, 2009 at 17:22 | #2

    BTW — You may have seen/commented it on it already but:

    http://www.marketwatch.com/story/einhorn-bets-on-major-currency-collapse-2009-10-19

    What do you think?

  3. Michael McDonough
    October 28th, 2009 at 17:52 | #3

    Joe,

    Regarding the link you just sent; I completely agree with Greenlight’s positioning. The lack of vol in Japanese rates has made options very cheap and ripe for the picking–so long as you agree with the underlying argument for rates to rise. I am fairly certain this is the trade of choice for funds investing in this hypothesis–along with straight shorts. In fact GS recently pointed out that JPY ATM 3y10y and 5y10y swaption vol is less than half comparable USD swaption vol. I have also heard some good arguments for long KRW/JPY.

    Unfortunately, at the moment I don’t have the time to respond to your first comment as thoroughly as I would like to, so I will likely postpone that to tomorrow.

    Thanks for the comments!

    -Mike

  4. John
    October 29th, 2009 at 11:56 | #4

    why not just short yen-dollar on the fx. you can do 50 to 1 leverage at oanda. yen-dollar bottomed around 86-ish last year. that is a pretty strong resistance, imo. i doubt it’ll even go close to that. it might go straight up from here and won’t look back until it hit 94-95.

  5. Joe
    October 29th, 2009 at 16:56 | #5

    John -

    What’s the point of making 5%ish? Without great risk control, or hedging, there’s no point in using that kind of leverage.

    Oh well, enough from an options trader who hates leverage :-)

    Mr. McDonough -

    I eagerly await your reply.

    I wonder about the counter parties to the Einhorn trade. My bet is that they are large (idiotic) Japanese banks, most likely the ‘tards over at Mizuho. But dont take it too seriously, My first wife, was ‘tarded. She’s a pilot now.

    As per your volume point — things are just slower in Japan, quants have not taken the kind of position that they have in the US.

    You have to understand, the government has not particularly cared about the stock market. They care about some aspects of the bond market, but they really treat stock with a certain amount of disdain. I’ve spoken with some about how equity financing is critical for VC formation; some understand the issue, but the older generations in particular look at you like you’re just trying to huckster them.

    And maybe they are correct.

    But what’s lacking is balance.

    Before this drags on too long Mr. McDonough, my basic point is that Japan is a massively complex and paradoxical country. It is the Bermuda Triangle of finance.

    Best of luck trying to navigate through it.

    Joe

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