Analysis from AdvisorAnalyst.com

Japan's Misfortune Good News for Canadian Market

Commodities and the Canadian dollar have continued to strengthen despite the rally in the U.S. dollar. That's odd, because for nine months, the U.S. dollar was involved in an inverse relationship with commodities, the Canadian dollar, equities, and emerging markets.

That relationship ended in late November as the dollar began its now, six-week old recovery.

It was often reported, from March to November 2009, that commodities prices were rising as a by-product of the falling U.S. dollar. That, indeed was doubly so. Speculative interest in commodities was driving prices higher, while rising short interest in the U.S. dollar, and record deployments of institutional cash were sending the currency lower, against the yen, and euro.

This combination brought the dollar to its knees in late November, and the Japanese economy to the brink of a deflationary collapse. This was not a sustainable combination. Not for Japan, not for the U.S., whose reservist currency relationship with the world is jeopardized by the threat of a collapsing currency, and, for that matter, the European Union, whose exports were crippled by the expensive euro.

There remains a discussion of the substantial risk of a sizable correction in commodities, emerging markets, equities, and the loonie, that has yet to happen.

Earlier this week I discussed Bill Gross' (PIMCO) investment outlook for January 2010. In it, Gross points out that, "most 'carry' trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their 'sugar daddy.'"

In late November, David Rosenberg, chief strategist at Gluskin Sheff, wrote, We look forward to a correction that allows us another opportunity to build long-term positions in this segment of the market where there are secular positive dynamics at play. But as we highlighted last week, anything connected to the U.S. dollar-carry-trade – a very overcrowded trade – is due for a correction."

On the assumption there is an absence of a "sugar daddy," both these statements are correct. We should remain concerned about the downside risk, as always, especially in the context of the recovery run we've seen since last March.

However, neither Gross nor Rosenberg touched on Japan's misery, courtesy of its untenably expensive currency, its deflationary slump, and its move to re-ignite the yen carry trade as an intervention mechanism, via its own quantitative easing.

At the end of November, the Bank of Japan competitively moved to ease rates on its short-term notes against the Fed's target rates, thereby making the yen cheaper to borrow.

A new race to the bottom, in the yen/dollar pair has begun, if Japan's new finance minister, Naoto Kan, has his way.

Simply put, our old "sugar daddy," is back.

Bloomberg reported on January 7, "Kan has been vocal in recent months in discussing the nation's economic challenges, pressing the Bank of Japan to step up its efforts to end deflation, and favouring a retreat in the yen's exchange rate that threatened exporters."

So why is that favourable for the commodity complex, Canadian equities, and the loonie?

Firstly, the liquidity created by Japan's easing moves provides support to markets giving institutional traders and investors the opportunity to "rollover" carry trades, covering short dollar positions and extending short yen funding positions simultaneously. The revived yen carry-trade is both useful as next-to-free money, borrowed for investment, and, the trade in forex pairs involving the yen could be potentially very profitable, given the currency's peak fiveweeks ago. It's certainly not a risk-free proposition, but, at present, the risk/reward relationship favours reward, based on the apparent zeal of Japan's finance minister to play a role in balancing global trade back in Japan's favour.

At the economic level, this turn of events is supportive to the global economy, to commodities demand, as is the emergent global recovery. While uncertainty about the long-term fate for the U.S. dollar persists, central bankers and foreign investors in China and Russia, for example, have continued to sponsor the Canadian dollar, Canadian companies, and our government bonds as the best alternative in the G7. As for markets, the re-ignition of the yen carry trade couldn't have come at a better moment. It means that commodity-weighted markets, like Canada's (and Brazil and Russia) will enjoy further investment, though not without some increase in volatility over the next several years.

Again, let's take a moment to realize that our situation would have been altogether different were it not for Japan's economic misfortune and expensive, yet free, currency.

On David Rosenberg's counsel, a correction in gold and the commodity complex would be another opportunity to increase long-term positions.