Friday, April 2, 2010

Keep an Eye on the Yen

The relationship between the euro and the U.S. dollar has captured most of the headlines recently, and that’s understandable given the problems with the PIIGS (Portugal, Italy, Ireland, Greece, and Spain), and the fact that the trade-weighted dollar index is so heavily weighted toward the euro (about 58%). But lately we’ve been watching the relationship between the dollar and the Japanese yen with a lot of interest as well. We hold small positions in our more aggressive strategies in Japan, mostly because of attractive valuations and because their equity market has underperformed so miserably that it may be due for at least a cyclical “mean reversion” trade. With the right catalyst we think Japan's equity markets could have significant upside even with the backdrop of poor demographics and much less robust growth than other countries.

The catalyst we have been waiting on is a weaker currency. One of the main problems with the Japanese economy for more than a decade has been a bout of chronic deflation. A weaker currency can help to counteract deflationary forces. Having a strong currency in recent years has hurt their economy, as well as stock prices. But the yen has recently been losing ground to the dollar, and appears to have broken above an important downtrend line on the news of a recently enacted fiscal stimulus package. With the largest percentage of government debt to GDP among developed economies, the currency has reacted negatively to the latest round of spending. The catalyst may have arrived.