Hedge Funder John Taylor Explains Why The Yen Has Been Tanking

John Taylor

Photo: CNBC

Is the tanking yen — which we just covered — a sign of some major problem coming to Japan?No, not really.

In a recent note, John Taylor of currency hedge fund FX Concepts explains what drives the yen… it’s basically risk appetite.

When people want to take more risk, they dump yen. And for the first time in a while, people are feeling good.

That being said, Taylor doesn’t expect this to last, and he expects the yen to hit new highs later this year.

Here’s his commentary.

Ever since the financial crisis began in 2007, the yen has been stronger than it should be.  The yen has been negatively correlated with the business cycle, just like the dollar is, but even more so.  When the financial system almost collapsed, hedge fund managers and other yen borrowers had to liquidate their assets and buy yen to repay their loans, resulting in a strong yen.  After the Fed and others stimulated the global economy, the yen should have weakened, but the weakness was minimal – something was different. Two things had changed.  Global growth was so forced and feeble that the Japanese did not invest enough offshore – they kept too much money at home – and hedge fund managers could borrow dollars for even less than it cost to borrow yen.  The dollar was safe too as the Fed didn’t want it to strengthen. Most of the missing outflow was Japanese, especially recently, as there is a school of thought among some hedge funds that Japan is very close to a major financial collapse, so as the Eurozone crisis deepened, they are establishing yen shorts to wait for Japan’s turn.
They will have a long wait.  Although Japan’s government debt is estimated around 220% of GDP, most of it is owned domestically, and netting currency reserves against its liabilities, their sovereign debt position looks more like the US or the UK.  When private assets are included, it is clear why the yen is so strong during troubled times.  We must conclude 2011 was bad enough that Japanese investors were more worried about return of capital than return on capital.  Only at the start of February did global things look good enough that the yen began to weaken. The good US numbers mean US rates will climb and higher rates mean a higher dollar.  The defensive position taken by most Japanese investors, with US assets hedged, means they are short dollars. Their lifting of hedges implies large yen sales, a trend that will run until exhaustion when hedges are removed and the dollar is much stronger.  However, it is more likely US growth disappoints, resulting in high risk, more Japanese repatriation and hedging, and a stronger yen – maybe as strong as 2008.  By early fall, the yen should be at all-time highs. A reversal of recent yen weakness will be the trigger that the US economic numbers are headed lower. However, if the recent trend away from consumer-led growth continues, reserve growth will extend its slow decline that began in August, and the lack of Asian money to buy US sovereign debt will drive US rates higher and the dollar up.  Although this bout of weak yen should end soon, after a period of yen strength, it should reappear in a more virulent form by year-end.

Bottom line: At least for now: What drives the yen is the alternation between risk on and risk off, whether Japanese investors are investing abroad, and whether hedge funders are borrowing in yen to buy various assets. When people are investing more and taking risks, that’s yen negative.

And of course, nobody in Japan is complaining. Manufacturers appreciate the breathing room, and the Nikkei index is doing just fine in the midst of the selloff.

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