March 14, 2011 / 8:21 AM / 9 years ago

FX COLUMN-Lesson from Kobe: short dollar/yen

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— Rick Lloyd is a Reuters FX Analyst and John Noonan is a head of Asia FX at IFR Markets. The views expressed here are their own —

By Rick Lloyd and John Noonan

SINGAPORE/SYDNEY, March 14 (Reuters) - For currency traders wondering what to make of the unfolding disaster in Japan, the earthquake that shattered Kobe in 1995 offers a few simple lessons: short dollar/yen, watch the flows and buckle up for what could be a white-knuckle ride.

The yen’s surge in the months after the Kobe disaster was driven by Japanese investors’ repatriation of foreign funds. Manufacturers, insurers and financial investors all sold overseas assets and brought the money home to cover reconstruction costs and portfolio losses.

The cost of rebuilding after the quake and tsunami that hit Japan last week will certainly require some sales of the net $1.25 trillion in offshore assets that Japanese investors bought between 2005-2010.

While all that money will not be needed for reconstruction, a wave of risk aversion after the quake will likely prompt retail and margin accounts to bring money home. The sliding Nikkei stock index , which plunged as much as 7.5 percent at one point on Monday, will probably help accelerate that process.

In 1995, that sense of fear was compounded by the collapse of British investment bank Barings under a mountain of debt from unauthorised trades run-up by Nick Leeson.

While the latest earthquake may not unmask another rogue trader, the trend in dollar/yen after the Kobe earthquake is worth recounting.

The yen was largely unchanged for four weeks after Kobe, closing at 98.52 on Feb. 14 compared with a close of 99.52 on Jan 17, the day of the quake.

Then dollar/yen fell to 88.60 on March 8 and closed the Japanese financial year at 86.60 before dropping to the all-time low of 79.75 on April 19. From there, the yen weakened steadily for over two years, touching levels above 126.50 in May 1997.

For all the parallels, there are many significant differences between the Kobe quake and tremor and tsunami that destroyed a swathe of northeastern Japan last week, even from the rather narrow perspective of a trader watching dollar/yen.

Apart from the scale of the disaster, there is timing. Last week’s quake struck much closer to the March 31 end of the Japanese financial year, when companies are more likely to sell foreign assets and bring money home.

Then there is the actual level of the yen, at just above 80 per dollar. Japan authorities are likely to be much more aggressive in their efforts to stall a yen rally that could harm a weak economy side-swiped by a major natural disaster.

After Kobe, the Ministry of Finance ordered intervention totaling a meagre 2,294 billion yen ($28 billion) between February and the end of April. The response this time is likely to be on a much larger scale, even allowing for the growth in foreign exchange volumes.

There are risks from derivatives known as “flat forwards” — derivatives that allowed importers, especially small companies, to buy dollars at a fixed rate. Hugely popular during a period of yen weakness in 2005-2007, they have left the buyers with large unrealised losses caused by the Japanese currency’s rally since then.

The flat forward exposure is another factor that could provoke Japanese authorities into an all-out battle with the foreign exchange market.

Still, a strategy of playing dollar and cross yen from the short side in the near term with a view to then selling yen at a future date seems appropriate. Those keen to capture both moves could consider buying yen puts in the 6-month to one-year tenor with a knock-in below the all time low, possibly between 75 and 70.

Those playing cash positions should be patient, but play the move from the short side looking to cover in late April or May and take any opportunities after that to get short yen.

Additional reporting from Harry Ida at IFR Markets in Tokyo $1=82.10 Yen

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