Is patience a virtue on JPY shorts?

“Fall seven times, stand up eight”           - Japanese Proverb

After a disappointing close for the week in US equities on Friday, a sharp and unwelcome deterioration in the Japanese Trade deficit and a tacit warning from ratings agency S&P that Japan’s sovereign credit rating may be at risk, today, the risk sentiment for the start of the new week was perhaps surprisingly upbeat.

The most notable impact in the world of foreign exchange has been the continued decline of the JPY. As I noted last Tuesday (The road to a weak JPY: a significant correction may be close) the potential for a decline in the value of the JPY has been apparent for a while now and while the persistent strength of the JPY, despite the underperformance (to put it mildly) of the Japanese economy for the past 20 years, has frustrated commentators and currency forecasters alike, this time things could be quite different.

The economic impact of a strong JPY is perhaps a bit of a moot point as while in the short term it puts pressure on export margins and global competitiveness, in the long run it boosts relative wealth and prosperity. Some economists may even argue that after so many years of deflation the ‘fair value’ in inflation adjusted terms is no longer so far away from its current level.

So why could this time be different?
Political consensus in Japan has long been difficult with a large number of political parties and a long history of 2, 3 or even 4 party ruling coalitions. However, while domestic politics are important (and indeed will likely become increasingly under the microscope – and probably to the detriment of Japanese economic forecasts and the JPY) the political developments in the US over the next couple of weeks and beyond may have a greater impact of the level of the JPY than any number of events in Japan.

Last laugh?
Tonight is the last of the US presidential debates and the implications from the impact in the key ‘swing states’ will be key to developments in financial markets. The JPY has not had a good correlation between a number of facets or factors that classical economic theory would say might effect a country’s exchange rate. However, one factor that retains a high correlation to the value of the JPY is that of US Treasury yields (particularly short dated yields). A convincing performance in tonight’s debate from Mitt Romney, whose disapproval of the US super easy monetary policy stance and the US deficit have been made clear, could well signal the start of a more meaningful move up in US treasury yields and a more meaningful move down in the JPY.

The US presidential debate will be of key importance to the USD in a broad sense, not just against the JPY, and as such I would not look to get too married to positioning in the build up to the elections, although the outcome of the election is likely to provide a more stable direction to the proceedings.

Recently there has been significant discussion about central banks that have embarked on quantitative easing (QE), simply cancelling the debt that the government issued and central bank bought with money created by expanding the money supply. The implications of this remain moot but if the side effect of a weaker currency happens to be desirable (as in the case of Japan) the possibility of doing such, instead of holding the debt to maturity, or selling the bonds back to the market (likely practically extremely difficult) increases.

Toe in the water, not both feet in the deep end
I continue to like the story of a significantly weaker JPY over the medium term, yet despite the backdrop becoming more encouraging, and Japanese authorities running out of policy options, remaining light or even on the sidelines ahead of the potential disappointment of a failure of the Bank of Japan to act next Wednesday (an outcome that is only too common in recent years) and the implications of the US presidential result is likely prudent.

JPY will likely decline significantly soon in my view, but in the very short term the volatility will likely increase and participating too soon may mean falling seven times, standing up eight … for now I would suggest awaiting confirmation.