How to Prepare for Inflation in Japan

Is it actually possible to have inflation in Japan? Well I guess anything is possible, but that is not the issue. Rather, it seems that absolutely no one in Japan (or the world for that matter) is positioned for inflation. The weightings of Japanese equities in investment funds is at record lows and government bonds (JGBs) are more or less at record highs, at least among Japanese investors.

However, the Japanese deflation "trade" may be in trouble. Commodity prices are steadily advancing in Yen terms. The CCI Index (the "old" CRB which is an equally weighted index of 17 commodities) continues to register multi-week highs.



And the CRB Index itself has just broken to a multi-week high due to crude oil playing catch up to the broad commodity group (the CRB has a about a 40% weighting to energy vs. the CCI's 20% weighting).



I have found that the behavior of commodity prices in local currency terms is he best leading indicator for inflation in a nation's economy. Both graphs above suggest inflation is about to hit in Japan. Already it seems as if property prices are on the rise as per this article from marketwatch. One wonders just how quickly things will move given how complacent Japanese investors are towards inflation. A JGB collapse would not be out of the question; perhaps sooner rather than later. I think one could do worse than buy deep OTM puts on JGBs, and OTM calls on Yen crosses including the EURJPY.

Note how volatility in the emerging market Yen crosses has fallen to almost zero over the last 8 months and as close to zero as you can get over the last three months. Something is about to give.

From experience I know that the longer a market moves in a sideways direction, the greater the intensity of the breakout. Given the positioning of weak hands, JGBs and the Yen are sitting time bombs. Ironically when they go off you probably want to be long deep OTM calls on Japanese stocks (yes calls not puts). A collapse in the Yen against other currencies would be the best thing that ever happened to the export heavy Nikkei!

Always position for the unexpected, by "default" if it is unexpected the risk/reward ratio will be heavily in your favor.

Disclosure: I am long EWJ, JOF, OTM LEAPs on EWJ