High Conviction: Short the Yen - Seeking Alpha

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High Conviction: Short the Yen

by: Alexander Tepper

March 10, 2010 | includes: FXY, JYF, YCL, YCS

Alexander Tepper is Chief Economist at TKNG Capital, a global macro hedge fund based in New York. Previously, Mr.Tepper was a senior economic policy aide to U.S. Senator Frank Lautenberg. He also has experience at Oliver, WymanCompany advising Fortune 500 financial institutions on risk management and as an investment banking Associate atCredit Suisse. He has a masters degree in Economics from Oxford University, and a BA in Physics from PrincetonUniversity.

We recently had the opportunity to ask Alexander about the single highest conviction position he currently holds in hisfund.

What is your highest conviction position in your fund right now - long or short?

We are short Japanese yen against the US Dollar. We have implemented the trade by selling out-of-the-money calls tobuy out-of-the-money puts and taking in premium.

Why did you use options to structure the trade?

Call options on the yen are significantly more expensive than put options. This “skew,” as it’s known, exists because theJapanese investment community tends to be short yen, making it susceptible to sharp rises during bouts of risk aversion

Investors hedge this exposure by buying out-of-the-money yen calls. But given the sharp adjustment that has already

occurred in the crisis and a government whose proclivities are far from fiscally conservative, we view the risks as lessasymmetric than implied by the skew.

Structuring this trade with options is akin to playing with dice load

in our favor.

Tell us a bit about Japan right now, and why you're short its currency.

Japan has traditionally been an export-oriented economy, but that’s going to change as the population continues to ageand retire. These older citizens, who have saved their whole lives and are no longer producing anything, will be a naturasource of demand, first for domestic Japanese goods and then for imports. A shrinking labor force will mean other nationwill need to pick up the slack in production. Already, the savings rate in Japan has fallen into the low single-digits and itshould fall further.





Japan is also in serious fiscal trouble. Its net debt is more than 100% of GDP, and gross debt is nearing 200% of GDP.The Japanese government and central bank do not seem particularly concerned. It is only Japan’s strong balance of payments position, and a willful suspension of disbelief by the markets, that differentiates it from countries like Greece. Bthose, too, should ebb over time.

So why will the yen fall?

First, as the Japanese retire, the supply shock to the economy will result in continuing declines in competitiveness. Theyen will need to fall to restore balance.

Second, less income and more retirees will mean that Japan will need to fund more of its government’s borrowing fromabroad. Making this attractive will mean a lower exchange rate, higher interest rate, or (most likely) both.

Third, the government’s fiscal position is the worst in the developed world. The scale of the adjustments that arenecessary to stabilize the budget deficit would be unprecedented in a large developed nation, requiring deep cuts topensions, double-digit tax increases, and severe spending restraint elsewhere. If sovereign worries persist, Japan and itcurrency are obvious targets for speculators.

Finally, we think consumers in the US and UK are undergoing a lasting shift in psychology that will cause them to save alarger share of their incomes going forward. Over the long-term, the savings rate needs to average around 10% in orderfor Americans to secure a reasonable retirement. When Americans save more, they buy less, especially imports. This laof demand for imports means a stronger dollar against US trading partners like Japan.

All this is on the assumption that the global economy will limp along for a while. But if instead we have a return to robustgrowth that looks broadly like the pre-crisis economy, the yen should weaken towards 2007 levels as markets becomemore and more comfortable with risk and interest rates rise in the rest of the developed world.

There are a lot of ways to win with this trade.

What would you say the current broad sentiment is on the yen?

The market has tended to view the yen as part of the “risk-on/risk-off” trade, where the yen rises with worries about theglobal economy. Japan’s fiscal issues are well-known, but the market has generally not priced them, with yields on 10-year Japanese bonds below 1.5%. Japanese CDS spreads, however, have doubled since late summer.

More broadly, the markets have believed that correction of global imbalances requires a weaker dollar to encourage

Americans and Asians to change their consumption behavior. We think the financial crisis and experience of house pricedeclines will be the driving force that restrains Americans’ profligacy, while Asians will consume more. The result will be stronger dollar.

Does Japanese economic policy play a role in your position?

The Japanese government has made fairly clear that it does not intend to tolerate a markedly stronger yen because ithurts their exporters. It also seems neither inclined nor able to do anything about the fiscal situation in the near future.

What catalysts do you see that could move the currency, and the trade in your favor?

The eurozone’s sovereign risk worries will soon resolve themselves one way or another. When they do, Japan could easbecome a target.

As economic data continue to strengthen over the next few months, a return to normalcy will mean a weaker yen.

We are also prepared for a more gradual adjustment as markets adopt our demographic view.

What could go wrong with this trade?

In the near term, Japanese companies repatriating income around the fiscal year-end in March could potentially lead to rise in the currency. A sharp rise in risk aversion could have a similar effect. We have been careful to choose the strikeprices on our options to minimize the damage if such a spike does occur.





Beyond that, deflation in Japan means that in a perfect economic world, the yen would appreciate over time. There is alsthe risk that the pundits over the past several years prove right and we see fundamental weakening of the dollar withrespect to all Asian currencies.

Finally, if China were to revalue its currency, as many believe it will, that could create space for the Japanese authoritiesalso to allow some appreciation. Again, however, we believe our options are sufficiently out of the money to limit our downside in such a scenario.

What are your thoughts on the short Yen ETFs now available to do this trade (DDY, YCS)?

I don't think any of the leveraged ETFs are suitable for retail investors. Their performance can vary markedly from theunderlying index over longer timescales. Just look at the performance of SRS (short real estate) since inception and yousee what I mean. As an individual investor, I'd do this using options on FXY.

Thanks, Alexander.

Disclosure: TKNG Capital is short the Yen against the Dollar.

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High Conviction: Short the Yen - Seeking Alpha

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