The sun also sets

In the March 23 issue of Forbes, I wrote that the yen was getting set for a downward move toward the ¥150 to ¥146.50, thereby effectively reaching my target. I had specifically recommended that my readers purchase one-year ¥140-to-¥150-dollar call spreads at a cost of 0.5%. Take profits on this position now at a price of 2.33%, a substantial return for 13 weeks. On a $1,000 commitment, you would realize $4,660.

Do I believe the dollar's rise is over? No. But option volatility levels have reached all-time highs, so option valuations are pumped up more than usual. Furthermore, the spot market is displaying near-panic characteristics. The likelihood is growing of a sharp corrective reaction to temporarily halt the dollar's rise. Don't be greedy. Take your profits.

This does not mean I am bullish on the yen. Eventually, I feel the dollar may very well attain levels closer to ¥160/U.S. dollar, and on a climactic selloff, the yen could tumble well beyond that level. The currency market has concluded that the measures the Japanese government has proposed taking are inadequate to check Japanese deflation. The recently approved ¥16 trillion fiscal spending package is simply the latest in a long line of fiscal spending that has produced no recovery. Japanese deflation persists, domestic demand is weak, bank lending is virtually nonexistent, and unemployment is worsening. Japan is a very rich country, but economic conditions such as these will eventually deplete its great wealth.

Ultimately, Japan will need to shock to make the necessary changes in domestic policy – and a further meltdown in the Nikkei could very well be the requisite shock. Reflation is a must, and in fact, Japan needs a dosage of inflation. Japanese consumers must feel that prices are likewise on a rising path so that private spending will accelerate.

But any turnaround will take a lot of work. It is hard to assess the impact of an asset deflation in excess of $10 trillion such as Japan has experienced since 1990, but the economic paralysis that Japan is now enduring is a fairly natural by-product. Bank balance sheets must be cleaned up of their $700 billion in bad loans, and lending must resume. The Bank of Japan can print yen day and night, but a real recovery will come only when banks lend, and people spend.

Japan's status as the world's second-largest economy and the largest creditor means that its problems are the world's problems—and these problems go very deep. They include an aging population, high levels of federal debt, a capital-impoverished banking system, and an overregulated economy. With its scandal-ridden, policymaking civil service largely stripped of all its power, Japan must also address the challenge of shifting policy information from the bureaucracy to the legislative branch of government. In other words, there will need to be major political reforms along with economic reforms. No wonder Japan seems virtually paralyzed.

Japan's woes are exacerbated by a regional sickness that looks quite frightening. Heavy storm clouds are gathering over Asia, and the risk is that in time the storm will spread to Europe and North America. Ultimately, the responsibility rests on the shoulders of Japan's policymakers, but to date, they have not been up to the task of carrying the load.

Conditions in Asia will probably get much worse before they get better, but—given the likely volatility—discretion right now is the better part of valor, and I recommend closing out my suggested bet on a declining yen. If the dollar sells off in a corrective move, then I would recommend the purchase of a ¥150 to ¥160 to the dollar call spread for a price of 0.9% and reinvesting a portion of the profits from the ¥140 to ¥150 spread.

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