Still Waiting for Japan’s Day of Reckoning

The “Abe Trade” is back on…for now.

The “Great Bernanke Scare” of May and June hit Japanese equities hard, forcing the Nikkei into “official” bear market territory (a loss of 20 percent or more is considered a technical bear market by most analysts).  But in the six weeks that have followed, Japanese stocks have recouped virtually all of their losses.

The yen—which tends to rise during times of crisis as traders cover their short positions—has resumed its gentle decline, and calm has returned to the Japanese bond market.  After more than doubling from  0.45% to 0.93%, the Japanese 10-year yield has drifted back to 0.78%.

What conclusions can we glean from this?

To start, Japan is indeed “back” as a risk asset class.  This is not to say that the Japanese economy is on the mend or that Japan’s long-term prognosis is anything but grim.  But after years of indifference, it shows that traders see the Japanese market as being worth trading.

Secondly, Japan’s day of reckoning—which will eventually come—is not here yet.  The bond market is calm—even complacent—and investors are unwilling to challenge the Bank of Japan.

So, what now?  Is it too late to jump on the Abe Trade?

In my view, yes—or at least for the first half of the trade, going long Japanese equities.  After roughly doubling in less than a year, Japanese stocks are no longer cheap.  By Financial Times estimates, Japanese stocks trade for 19 times earnings and yield only 1.6% in dividends, making them downright expensive by world standards.  As a point of reference, the U.S. S&P 500 trades for just 16 times earnings and sports a dividend yield of 2.5%.  German stocks trade for less than 13 times earnings and pay out 3.5% in dividends.

But what about the second half of the Abe Trade—shorting the yen?

This would seem like a low-risk proposition. Barring another jolt of “risk off” volatility that led to short covering, it’s hard to see a scenario whereby the yen appreciates from here.  The Japanese government is determined to push down its value, and the near-zero yields across the yield curve offer little in the way of resistance.

In a benign environment, shorting the yen should produce modest, albeit positive returns.  But if I am correct about Japan eventually having a capital markets meltdown, then those modest returns could get eye-popping in a hurry.

The key here is the bond market.  If the bond vigilantes finally awaken from their slumber and push Japan’s borrowing cost to something that actually reflects the underlying risk, Japan will be effectively locked out of the international bond market.  It will be forced to commit that cardinal sin of turning to the Bank of Japan for financing…which will turn the yen’s orderly decline into a rout.

If you want short exposure to the yen, consider shorting the CurrencyShares Japanese Yen Trust ($FXY).  And put the PowerShares DB 3x Inver Jap Gov Bond ETN ($JGBD) on your watch list.  When Japanese yields start to rise again, JGBD will put you in position to profit.

Charles Sizemore has no position in any security mentioned.  This post first appeared on MarketWatch.

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