Japan – the flow is gone –

The main story since the September crisis has been the ongoing capital flow back to Japan. A combination of high volatility and increased risk aversion caused Japanese investors to pull capital back home. and reverse the carry trade that has been going on for years. The great yen rally is now over because the economics in Japan are so poor. We are seeing yen depreciation and flows back out of the country.

The poor Japanese economic environment is driven by two factors. These two factors are so strong that it more than offsets the home bias that most investors feel and the fact that world rates are low relative to Japan. One, there is significant political uncertainty associated with the Japanese government. With the Finance Minister resigning after an overdose of cold syrup, there is a lack of confidence on whether the government can properly address the economic crisis. There is a shortage of leadership and new ideas. Two, the economics in Japan are bad. Industrial production and exports have fallen off a cliff with new extremes being hit every month. Factory orders, industrial production, and exports are all falling at double digit rates. This is worse than the lost decade. The stock market is weakening and the Bank of Japan is involved with buying corporate debt.

The yen had been highly correlated to the SPX but that trade of buying yen on US stock weakness is over. The weakening of the yen has taken place eevn with the SPX declining.

There is actually a move back to higher yielding investments especially corporate bonds. This may be the beginning of the new carry trade, the combination of stronger fundamentals and higher yields is starting to attract capital evn though the carry is into risky assets.