For our first post, here are some interesting subjects to watch this year (written in the beginning of last week)…
1. Euro under pressure after a good year:
Last year, the Euro (as the GBP) has remained traders’ and investors’ favourite currency to hold in the middle of this monetary expansion system. Since Draghi’s words ‘whatever it takes’ in late July 2012 with the introduction of the OMT plan a week later, the spreads between peripheral and core countries (the one to watch is the German-Spanish 3–year spread) have narrowed to levels we have seen in 2008/2009 prior the Euro zone debt crisis. As you can see it on the chart below, the 3-year spread between core and peripheral countries (Germany vs Spain in yellow) have decreased from a high of 746 bps (on July 24th 2012) to a 3-1/2-year low of 119 bps today, while the single currency (in red) strengthened from 1.2060 to 1.3600 against the greenback during the same period.
Moreover, despite disinflationary pressures in the Euro Zone (EZ CPI printed at 0.9% YoY in November, well below the ECB’s inflation target of 2%) and a private sector loans contraction (ECB data showed that loans to the private sector dropped by 2.3% YoY in November, its 18th monthly decline and the sharpest since the start of the single currency in 1999), policymakers haven’t reacted in a strongly dovish attitude to counter a weak growth/weak inflation environment. The only response from Draghi was to cut its refi rate by 25 bps to 0.25% in November, an action which was already priced in by the market and didn’t impact the Euro. One indicator that we like to watch quite a bit is the Fed-to-ECB balance sheet ratio (Total Assets). If we have a look at the graph below, after the Fed introduced its QE4Ever last December announcing that it would start purchasing $85bn of US Treasuries and MBS every single month in order to stimulate the economy and lower the unemployment rate to 6.5-7 percent, the ratio surged from 0.73 on January 1st to 1.29 today. At the same time, the size of the ECB balance sheet went down 23% in 2013, from 3.1tr EUR to 2.3tr EUR, strengthening the single currency.
We believe that we may see a Euro under pressure in the coming weeks, with a market keeping a close eye on the ECB next several meetings and a potential action from policymakers if the annual inflation rate keeps running low in the medium term. The spike we saw on the single currency at the end of last year was mainly due to a lack of liquidity in the market (as traders had already closed their books), therefore the buyers (mainly banks) pushed the Euro higher with EURUSD hitting a new high of 1.3892 on December 27. We don’t expect any reaction from the ECB at the next meeting this Thursday; however a potential action (LTRO3) will cap the Euro on the topside in the medium term. The trend starts to look bearish on EURUSD; it may be a good time to short the pair above the 1.3650 level for a long-run position (first target at 1.3400).
2. A parallel shift between the fiscal and monetary policy:
At their last FOMC meeting (December 17-18), US policymakers announced that the Fed will reduce the pace of its asset purchase program by $10bn to $75bn ($5bn cut in agency MBS and S5bn in US Treasuries). In addition, from what we heard during Bernanke’s last conference, if the jobs gains continue as expected, the purchases would likely continue to be cut at a ‘measured pace’ through the next 8 meetings. In other words, QE4Ever would potentially come to an end in December 2014. We won’t argue with the fact that US macro figures have constantly improved for the past few months, with an unemployment at 7% (compared to 7.9% in January 2013), final Q3 GDP that came in far above expectations at 4.1% QoQ (vs cons. 3.6%) or Housing Starts back above the 1-million level (1.09M in November). However, here is another interesting point We have read that could explain the Fed’s decision. As you can see it on the chart below (Source: CBO), between 2009 and 2012, the US have constantly run a $1tr+ deficit ($1.1tr in 2012). At the end of 2013, the Treasury and Office of Management and Budget announced that the US deficit decreased by 37% to $680bn for the FY 2013, which could be explain by the sequester cuts and tax rates going back to historic norms.
At the same time, the Fed injected approximately 1trillion USD in 2013 with its asset purchase program, which leaves $320bn of hot money coming from the Fed that flew to sexy assets such as the stock market and the real estate market. In 2013, the S&P index went up 30% to close at 1848 and the housing market surged by an impressive 10-11% according to some indexes such as Case-Shiller or CoreLogic. Therefore, in order to calm down the asset price inflation (especially in the stock and housing markets), US policymakers have decided to follow the fiscal budget deficit, which could potentially lead to a sharp correction in the equity market in the second semester of 2014 with a much lower growth concerning home prices.
3. Fed Tapering and PBoC reducing liquidity: a threat for EM markets…
Since the last quarter of 2008, it was reported that Chinese bank assets have grown by an outstanding $15tr, which of course contributed to the global demand in commodities and stimulated EM markets and some G10 countries strongly relying on exports such as Australia or Canada. However, it seems that the easy credit period is coming little by little to an end, and therefore will add pressures on those countries that have seen their economic statistics inflated due to the loose monetary policies run by central banks. According to some estimates, it was reported that the People’s Bank of China (PBoC) have injected a net total of 113.8bn Yuan (equivalent to $18.7bn) into the country’s banking system in the year 2013, which is 92% less than the previous year. We saw some sharp moves in China’s money market rates during the month of December, with the interbank 7-day repo rate that spiked above 8% on December 23. Even if the inflation rate remains at a reasonable level (according to the National Bureau of Statistics of China), the PBoC could halt the liquidity crisis by simply injecting more and more cash, however it wouldn’t solve the problem there as Patrick Chovanec (Managing Director at SilverCrest Asset Management) says ‘loose monetary policy is the problem, not the solution’.
Therefore, a slowdown of the world’s largest economy this year will first hit the EM markets in our opinion. The chart below shows the EM currencies that have already started to react to next year’s environment (ZAR, IDR, THB, MYR and RUB).
Furthermore, with the Fed starting Tapering this month, we would hold a long USD vs EM basket (or short EM equity markets) on these 5 currencies as we believe the situation will continue to worsen.
4. UK: Good fundamentals in addition to a less-than-expected BoE Governor may continue to act in favour of the British pound in early 2014
Since the beginning of July, the British pound has increased against all the currencies and was traders’ favourite currency to hold in the second semester of 2013 (even against the Euro). First of all, the appreciation of the currency can be explained by the strong fundamentals we have seen in the past few months. The GDP in Britain expanded 0.80% QoQ in the third quarter of 2013 and is expected to grow at an annual pace of 1.9% according to the IMF’s October Forecast (up from July’s projection of 1.5%). PMIs are all well above the 50-recession, with manufacturing PMI printing at 57.3 in December and Construction PMI coming in at 62.1 on Friday. In addition, according to Nationwide building society, the average price of a British home increased by 8.4% in 2013 (with London on the top with its 15% increase over the year), contributing to the economy’s recovery. Secondly, with Mark Carney joining the BoE in the beginning of July and introducing forward guidance (BoE intends to keep the Official Bank rate at a historical low of 0.5% until unemployment rate hits 7%, as long as inflation remains under control), the market reacted positively with traders and investors starting to bet that UK policymakers will start to raise interest rates sooner than expected. In fact, with the unemployment rate that fell from 7.7% to 7.4%, strategists are predicting that the 7-percent threshold will be hit in 2015 instead of Q3 2016 predicted by the BoE when Carney introduced the forward guidance. One indicator that we have been watching is the UK-US 2 year spread. As you can see it on the graph below, the 2-year spread has been one of the GBPUSD drivers for the past 6 months and has increased from 0 to 7.07 bps.
With the Fed starting to taper this month, we would prefer to hold long GBPAUD and GBPCAD positions for the start of this year, or even be short EURGBP looks good to me in the short term.
5. Abenomics: A speculative story to continue in early 2014
A. Quick Japanese recap story
Since the private sector debt bubble burst in the early 1990s, Japan had been stuck in an ‘ugly deflationary deleveraging’ (also called the ‘Lost Two Decades’). For the past two decades, real growth has averaged 1.1% with a persistent deflation of -0.5%. This situation has led to an exponential expansion of the government debt which crossed the one quadrillion yen mark last August and a debt-to-GDP ratio of 219% (according to Bloomberg index GDDBJAPN Index), the highest in the developed world. To give you an idea, Japan’s debt is larger than the economies of Germany, UK and France combined.
Moreover, if you add in private and corporate debt, total Japanese debt stands at 500% as a share of GDP.
With 10 different FinMin and 7 PrimeMin since 2006, the Japanese economy was desperately in need of a grand strategy. Therefore, the re-elected PM Shinzo Abe announced in December 2012 a suite of measures called Abenomics. His goal was to revive the Japanese economy with the so-called ‘three arrows’:
1. Massive fiscal stimulus : the government announced in January 2013 that it will spend 10.3tr Yen in order to generate some growth, create about 600,000 jobs and increase the inflation rate
2. Quantitative easing : On April 4, the BoJ introduced its QQME ‘quantitative, qualitative monetary easing’ program in order to reach a 2-percent inflation, a program where the central bank will double the size of its monetary base from 138 to 270 trillion years over the next two fiscal years (fiscal year runs from April 1 to March 31 in Japan). The amount of holdings of JGBs will increase by 100 trillion yen by the end of the fiscal year 2014
3. Structural reforms : This is more a LT projects where PM Abe wants to increase Japan’s real economic growth rate to 3% by 2020 (compare to the 1%+ of the last two decades). The LDP party has several targets such as to foster trade, provide excellent education, raise women’s labour participation rate, improve infrastructure exports, reconstruct the Tohoku region…
A Good Year…
Since December 2012, the Japanese economy has reacted quite well with a stock market that rocketed by 66% (Nikkei index went up from 9,500 in mid-December 2012 to 16,000 at the start of this year) and the Japanese yen has depreciated by 26% up from 83.00 to 105.00 in the same period. If we have a quick overlook at the fundamentals, annualized Q3 Final GDP printed at 1.9% QoQ (down from 3.8% the previous quarter though) and the country’s annual CPI (overall Nationwide) posted its highest rate for nearly five years at 1.5%. In addition, housing starts rose 14.1% YoY in November and December manufacturing PMI printed well above the 50-recession level at 55.7.
After we saw some perturbations in April/May 2012 especially with the volatility in the bond market spiking to ten-year highs (JGB 10-year yield rose from 45 bps to 94 bps) which led to a sharp May-June correction of 20% in the stock market (with USDJPY down by 8.9% to 94.30 at the same time),we are very curious to know if the new bullish trend we have seen since the beginning of November last year is going to continue in the coming months.
B. Early 2014 outlook
Firstly, we think that the market now trusts the BoJ since its numerous hints from its Governor Kuroda (the BoJ ‘would not hesitate to take further measures if the economy stopped moving in line with its projections’) in the last few meetings, a strong and positive factor for both the JPY and the Stock market. When he mentions the economy,we believe he especially tells his nation (and the investors) that the BoJ will do whatever it takes to avoid any kind of sharp moves in the bond market. As we all learned at university, growth/inflation is the worst scenario for the bonds’ investors. For example, we already heard that GPIF, the world’s largest government pension fund (and holder of Japanese bonds), was holding too many domestic bonds. Takatoshi Ito, the head of GPIF, said in an interview last December that GPIF needs to reduce its bonds share to 52% of its total assets (58% was the share recorded in September 2013) and re-allocate a higher proportion in the domestic stock market and foreign investments (stocks and bonds). An interesting letter to read was the one published on June 5 2013 by Kyle Bass from Hayman Capital, where he talks about the ‘rational responses to the new monetary plan’ and the 5% of JGB ‘rational’ sellers (5% of a quadrillion yen in debt equals 50 trillion yen in money, almost the 60/70 trillion purchases from the BoJ).
Secondly, with the Fed starting to taper this month (and likely to continue to reduce the pace of QE during this year), we think that the Yen should continue to rise steadily against the US Dollar. One graph we like to watch is the 10-year T-Note yield vs. USDJPY. As you can see it on the chart below, QE Taper means higher yields in the US (10-year US currently trading at 2.95%) which tends to drive the pair higher (trading slightly below 105).
Therefore, the divergence between the two monetary policies (Fed vs BoJ) should strengthen USDJPY in the medium term. Our next target stands at 107/107.50.