Description

Why would one be concerned about Japan's currency and/or rates?

While the world is obsessing over sovereign debt problems in Europe and concerns of a macro slowdown in the US, Japan certainly has its own problems brewing.  I won't review the entire macro discussion here, as it is well-documented, but in summary:

• Japan's debt/GDP exceeds 200%, by far the largest debt burden among advanced major economies.
• Japan's population has historically purchased large amounts of JGBs, which has helped the government finance deficits internally. However, Japan's population is aging and is now at the brink of moving from away from being a net savings society in this process. Certainly, the aging of the population is a glacial process, but demographic data suggest could be nearing a reversal of Japan's position as a net savings economy.
• Although Japan's economy has grown more in recent quarters, its government's own forecasts do not foresee much more than 1-2% real growth, which would certainly make growing out of its national debt burden highly unlikely.
• Japan's economy has relied on export-oriented growth which can be compromised by a strengthening yen, and the government has announced various actions to preclude a strengthening (and even promote a weakening) of the currency such as through direct intervention in the currency markets on August 4. The yen is currently near its post-World War II high relative to the dollar, which it reached in recent weeks.
• Two days ago (Aug 24), Moody's just cut Japan's credit rating to Aa3 citing weak growth and concerns over its public debt burden.

We are concerned about the sustainability of Japan's fiscal situation, but we cannot predict the timing of when the market might act more forcefully on the situation. Much like Europe, once it does happen, we believe it could happen quickly.  While insufficiency in dealing with its dire fiscal position could lead to a spike in JGB yields under such a scenario, we also think it may likely be preceded by a decline in the value of Japan's currency.  Indeed, while the government would surely do everything it could to resist a rise in borrowing costs, it would seemingly welcome deterioration in the yen to enhance export competitiveness.   As such, we focused on yen puts as the nearer-term hedge instead of JGB rate caps.

As always with these insurance products, timing can be an issue.  We think the overall facts are difficult to argue, but predicting the precise timeframe is impossible.  (Japan retains the broader Pavlovian status as a "safe haven" today.)  Consequently, an investor needs products that deliver sufficient bang-for-the-buck and allow for purchase of large notional amounts for minimal costs.  Below, we present the payoffs for 6 month and 1 year put options on the Japanese yen at various strikes.  Although we are not predicting and hoping for a breakdown of the yen or a spike in JGB rates, we think investors should be aware of the risks, both to Japan and the global economy, and are wise to consider some insurance on such a scenario.  We do not have a specific prediction for how severe the decline in the yen could be, but we do note that the JPY/USD fx rate was over 100 as recently as 2009 and in the 120s as recently as 2007.  For simplicity's sake, we assume an upfront premium of $1 mm for each scenario.  On the next page we show 6 month contracts and 1 year contracts, both on out of the money puts struck at 90 and 95 (this is meant to be insurance after all!).  At levels of 100, an investor would make ~10-37x based on these products and at 120 would 30-140x payoffs.

Payoff Profiles

Catalyst