Dividend Stocks

The Bank of Japan Could Trigger a Giant Short Squeeze

I know, you’re probably tired of me talking about Japan and the reverse carry trade thesis. But I just can’t help myself when I see more evidence of just how fragile things truly are. The idea is simple: There’s a tremendous amount of leverage that comes from Japan because of how low its interest rates are. The differential in yield between the U.S. and Japan basically means there is a big incentive for global investors to borrow in yen, effectively shorting the currency. These investors then deploy this borrowed capital around the world.

The more the yen depreciates, the more oil priced in yen increases, and the more likely the Bank of Japan must intervene.

There’s a real battle going on. According to Bloomberg, there are a record number of contracts betting against the yen. Speculators are challenging the Bank of Japan’s resolve in a historic way.

Every single intervention to prop up the yen has failed. The only way the Bank of Japan can succeed in future intervention is by taking an ultra-aggressive stance that scares the shorts out of their positions. This will require a massive buying of yen to cause pain to speculators, and which in turn could create short-covering rally in the currency.

This is also the exact order of events I’ve been warning could trigger the reverse carry trade.

The Bottom Line

None of this has mattered… until now. As short positions against the yen increase, the more likely that trade will reverse… and do so viciously. And I don’t think anyone is prepared. Not the U.S., and not even Japan.

The only way Japan gets saved is if oil prices were to collapse faster than the yen has. The entire thesis is predicated on Japan panicking because of oil priced in yen.  And it’s worth noting that oil has been surprisingly resilient while other commodities have pulled back. If oil were to surge from these levels, it makes the Japan situation even more dire. If oil were to crack, it buys Japan time without the BoJ needing to purchase yen.

My contrarian antennas go up when I see what’s happening with yen short positioning. Can it get more extreme? Absolutely. But we are at a point where it won’t take much to reverse a very crowded trade and shake up global volatility as a result.

On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

The Lead-Lag Report is provided by Lead-Lag Publishing, LLC. All opinions and views mentioned in this report constitute our judgments as of the date of writing and are subject to change at any time. Information within this material is not intended to be used as a primary basis for investment decisions and should also not be construed as advice meeting the particular investment needs of any individual investor. Trading signals produced by the Lead-Lag Report are independent of other services provided by Lead-Lag Publishing, LLC or its affiliates, and positioning of accounts under their management may differ. Please remember that investing involves risk, including loss of principal, and past performance may not be indicative of future results. Lead-Lag Publishing, LLC, its members, officers, directors and employees expressly disclaim all liability in respect to actions taken based on any or all of the information on this writing.

Michael A. Gayed is the Publisher of The Lead-Lag Report, and Portfolio Manager at Tidal Financial Group, an investment management company specializing in ETF-focused research, investment strategies and services designed for financial advisors, RIAs, family offices and investment managers.

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