Is The Market Worried About The Wrong Deficit

Submitted by Nic Lenoir Of ICAP

Finally we are starting to hear more and more chatter about short JGB trades, long USDJPY, and concerns being voiced about the Japanese deficit. It is dramatic that the US is going to end up getting from 65% to 80% debt to GDP ratio in a matter of months, but before the gold bugs and short-USD carry traders get too excited, maybe they should think whether it is indeed time to increase the use of the USD for the financing of their trading positions. Japan is flirting with 200% debt to GDP ratio. Granted the consumer in Japan has the advantage of a strong savings compared to its US counterpart. However, a ballooning debt and a shrinking population is the kind of leverage economic disaster is made of. Throughout the 90s Japan has enjoyed a strong net positive trade balance, though it hasn't really materialized in much growth. However the crisis in 2008 inverted that, and even though Japan's trade balance has made a comeback to positive since, we are still at the low end of the what was the range for the past 15 years. Meanwhile the US trade balance deficit has shrunk by half. If the G-20 intends to make good on its commitment to reduce trade imbalances, then certainly that is one advantage Japan loses over the US.

Moving on to rates, 10Y JGBs yield a mere 1.45% compared to 3.53% for 10Y US Treasuries, and the Japanese CDS is wider, so the imbedded risk free rate spread is even wider between the two. Recently JGBs have sold off, but nothing compared to US treasuries since March overall. Interestingly from a credit standpoint we see the opposite as the Japanese CDS has been widening a lot more than the US CDS, especially this past month.

As for the currency, we can see that the USDJPY has been in a wedge from 1198 to 2008. We have exited to the downside, but I think it is a case of a throwover and we are going to end up breaking out to the upside. The monthly RSI does not validate at all the recent lows made, in fact we bounced of the trend support in RSI. Part of this excess to the downside is due to excessive weakness of the USD, but also to the coincident repatriation of money in Japan as deleveraging and risk aversion struck the market last fall. It is only the unique combination of these two factors that brought us to these levels. Looking at it more closely, we see that the we had strong weekly divergence as we retested 88 in October. The sell-off from April to early October is a perfect A-B-C with C=A almost to the pip. Then the sell-off from October 26 to November 1 is perfect a-b-c correction with c=a if you exclude the slight intra-hour excess, and a retracement between 61.8% and 76.4% from the highs of the 26 (hourly chart). SO technically we have many elements indicating we could be on the verge of sharp move higher. Short-term the minimum target I see on the upside is 93.54, but I am fairly confident we will test the medium term bearish channel at 96.25. Further out there is a key resistance at 101.34 which if broken opens the way to the real big underlying macro move that I think is in the card. Macro models suggest the cross is worth closer to 120/130 than 90. Only risk is a retest around 89.29 in the very near term, but I would suggest buying between 90.15 and 89.86, and possibly add at 89.29 should we get there. only a weekly close below 88.80 would suggest that we need to wait further before entering the trade.

For traders in rates space, selling JGBs is the most sensible way to express the view. we would recommend to wait a pull back to 139, or otherwise sell on a break of 137, and add if we bypass 135 on the downside. A retest of 130.75 is quite likely, and only a bypass of that level would mean we are at serious risk of seeing a trully powerfull acceleration. I think this final case would be synonymous with a much wider Japanese CDS and severe concerns about the fiscal situation. It would also probably mean that for the first time since the 1990s the Japan retail customers lose faith and appetite earning under 1.5% no matter what other risks are out there. A break of 130.75 could well be that tipping point.

So there are three ways to play this view on Japan. Credit traders can buy the CDS, but as we see the price has doubled in a month. Rates traders can sell JGBs. The recent sell-off in the past few weeks is related to the widening in CDS, but we feel there is definitely room for further downside, either selling a bounce to 139, or a break of 137. Finally in the FX market, USDJPY remains very close to the lows in over 10 years, and if the USD woes dissipate a bit we feel this is a trade that could have a lot of upside. After all we have seen recently a plethora of large macro traders talk up the USD in the media, including Jim Rogers who is so bearish USD that he moved to Singapore. If the fact that the UUP long USD ETF ran out of shares is any indication, it might be time to focus on an other weak currency...

Good luck trading,

Nic