Hedging Yen amid bullish Nikkei outlook? The Nikkei-225 is trading near 40,000 once more. The sharp decline in early August due to the BoJ rate hike has been swiftly reversed. The outlook for the Nikkei remains bullish with continued investor interest driven by market reforms as well as foreign investor interest.
With the BoJ currently on pause and signalling no urgency to raise rates further, the Nikkei appears poised to retest its all-time high set in July. However, the significant influence of monetary policy on the Yen makes it advantageous to hedge a Nikkei position with a long Yen position. This approach offers similar upside potential while reducing downside risk.
BOJ ON HOLD FOLLOWING FALLOUT FROM RATE HIKE
The BoJ decided to maintain rates at 0.25% during its September 20 meeting. Their statement indicated that the economy is on a recovery path aligned with the BoJ's mandate, upgrading its assessment of consumption from a "resilient trend" in July to a "moderate increasing trend."
Governor Ueda noted that the recent yen strengthening is reducing inflationary pressures, signalling positive trends for the economy in line with the BoJ's mandate.
During the September 20 meeting, he reiterated that the BoJ would not raise rates amid market instability, which they attribute to recession risks in the U.S.
This cautious approach likely results from the fallout after the BoJ raised rates to a 15-year high at its July 31 meeting. This decision triggered a sharp yen appreciation and a significant unwind of the yen carry trade, leading to a global decline in equities fuelled by fear. The Nikkei-225 dropped over 20% in the following week, erasing all gains made in 2024.
MARKET STABILITY ANOTHER CONCERN FOR BOJ
The BoJ's policy mandate focuses on achieving sustainable economic growth through wage growth and consumption while maintaining a stable 2% inflation rate. Under Governor Ueda's leadership, the BoJ aims for a neutral policy rate that is neither overly restrictive nor too accommodative, indicating that rates must increase from their current excessively loose levels.
However, following the market reaction to the July 31 policy meeting, the BoJ faces an additional mandate: balancing its monetary policy trajectory with the risks of market volatility and its effects on business stability.
This additional mandate introduces a complex variable into the BoJ’s monetary policy balancing act, making it prudent for the BoJ to wait and assess the effects of policy changes. As Governor Ueda stated during the policy announcement, "We can afford to spend some time in making a policy decision."
The BoJ has two remaining policy meetings scheduled for 2024: October 30 and December 18. Following Governor Ueda's recent statement highlighting risks from market volatility, analysts unanimously agreed that September policy meeting would not result in a hike but majority still expect another hike by the end of the year.
With the recent encouraging inflation prints, BoJ has room to hike rates towards the end of the year.
PAUSE RATHER THAN HALT
The decision to maintain rates may signal a pause rather than a halt to rate hikes.
Governor Ueda indicated in an August parliamentary hearing that the BoJ would continue to raise rates if economic data aligns with expectations. With inflation around the target range, BoJ has room to raise rates further.
Additionally, the recent election concluded with Shigeru Ishiba becoming the next Prime Minister. The former defense minister has backed the BoJ's rate hike strategy and expressed concerns about yen depreciation. His leadership may foster political support for further rate increases in Japan.
Finally, recession fears in the US are subsiding with recent jobs data and GDP figures above expectations. This may help ease market instability concerns for the BoJ.
JAPAN EQUITIES REMAIN COMPELLING, ATTRACTING INFLOWS
Japan equities remain compelling for foreign investors. The TSE’s recent market reforms have led to a material improvement in the firm’s balance sheets with higher utilization of capital in the form of both returns to shareholders and capital expenditure.
Furthermore, Japan equities remains undervalued despite the massive improvement in valuations this year. While, the P/B ratio for Nikkei-225 has increased from 1.75 to 1.93 over the past year, the P/E ratio has remained largely unchanged at 20.88 (compared to 19.38 last year). The much unchanged P/E ratio reflects the strong earnings growth despite the 23% rally in the index.
The potential undervaluation has attracted global value investors including Warren Buffet. Warren Buffet has built up large positions in Japanese trading houses with the value totalling nearly USD 25 billion as of 12/June. Buffet has previously opted to increase stakes in these investments when they traded at P/E similar to the level during the downturn in August.
Furthermore, YTD inflows into Nomura Nikkei 225 Fund (NTETF) have totalled USD 891 million. While the fund is only available OTC in the US, it is one of the largest Japan equity ETF with USD 71 billion in AUM. Notably, inflows into the ETF have been concentrated after large declines this year suggesting investors are using decline in price to increase positions.
CHINA STIMULUS ADDS FURTHER WIND IN NIKKEI SAILS
The announcement of the massive stimulus package in China last week has supported most Asian equity markets with the rising tide of Chinese equities rippling through Japanese equities.
As the positive sentiment in China continues, other Asian indices are likely to benefit too.
HYPOTHETICAL TRADE SETUP
The Nikkei-225 is supported by strong tailwinds including market reforms that support foreign investment and a positive sentiment in Asia equities.
However, given the market reaction to the previous BoJ rate hike, monetary policy and Yen moves remain a pertinent concern for the Nikkei.
Nikkei and Yen are inversely correlated. The correlation is particularly tight during periods of Nikkei decline.
With the Yen remaining volatile from the impact of monetary policy, hedging a long position in Nikkei-225 with a long position in the JPYUSD is prudent.
A combined position of being long on both the Nikkei-225 and the Yen has delivered similar gains to a long position in the Nikkei-225 over the past three months. However, the combined position has also offered crucial downside protection, outperforming during periods of market decline.
The Yen remains on an uptrend, supported by both a weakening dollar from Fed rate cuts and a strengthening yen from BoJ rate hikes.
A position consisting of long CME Nikkei (USD) futures can be combined with a position consisting of 2 x long CME Japanese Yen futures to roughly balance notional across both legs. Investors can also deploy 21 x long CME Micro JPY/USD futures to balance notional more closely. CME provides margin offset amounting to 35% as of 27/Sept for this trade which reduces margin requirements from USD 18,720 to USD 12,168.
A hypothetical trade setup consisting of long 1 x CME Nikkei (USD) December futures and long 21 x CME Micro JPY/USD December futures offering reward to risk ratio of 1.43x is provided below.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme .
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