Great Chart: USD REER vs. VEU/SPY

An interesting observation arises when we plot the annual change in the US Dollar with the relative performance of US vs. World (ex-US) equities. As you can notice it in the chart, the World (ex-US) equity market tends to outperform the US market when the US Dollar is weakening. For instance, the US Dollar (USD REER) performance in 2018 led to  an outperformance of US equites (SPY) over World (VEU) up to 20% before the last quarter.

In addition, this chart shows that the annual change in the USD tends to mean revert over time, fluctuating between -10 and +10 percent. Hence, investors could not only benefit from playing the range on the greenback, but also speculate on equity relative performance between US and non-US stocks. As we expect the US Dollar to weaken through the course of the year, this could lead to a significant performance of the world (ex-US) equities. A weaker USD also eases the pressure in the EM corporate bond market, which is heavily USD-denominated, and therefore loosens financial conditions.

Chart. USD REER vs. US / World (ex-US) equities – YoY Change

 

Is it time to go long UK financial assets?

Last year, there were worries that the continued depreciation of the British pound was going to increase inflationary pressure in the UK economy and therefore force policymakers to start a hawkish tightening cycle. With uncertainty still significantly elevated, demand for Gilts would keep UK LT years at low levels and many analysts predicted a potential ‘yield curve inversion’ as one of the main outcomes for this year.

However, over the past few months, the fall in oil prices in addition to the 12M lagged currency ‘effect’ have been pressuring inflation expectations to the downside. Our model, which incorporates the annual change in currency and oil prices as two key inputs, has been predicting a correction in future inflation prints in the UK (figure 1, left frame). Therefore, with the short-term implied yield curves Dec19 Mar19 and Dec20 Dec19 trading at 19.5bps and 15bps, respectively, the market expects slightly less than two hikes by the end of 2020 (figure 1, right frame). This leaves policymakers more flexibility concerning their interest rate normalization policy after warning that Brexit uncertainty ‘intensified considerably’ in the end of last year.

Figure 1

Inflation model

Source: Eikon Reuters, RR

Mixed signs from leading indicators and surveys

As for many developed countries, industrial production has contracted significantly in the few couple of months of 2018, down 1.5% YoY in November. However, we can notice that our leading indicator recently ticked up and therefore is pricing a stabilization in the UK business activity (figure 2, left frame). It is still too early to switch our forecast to positive and therefore the next few data points will be important to watch in order to take a fundamental view on UK financial assets. On the other hand, the CFO survey from Deloitte is standing at 2016 critical levels, as CFOs expect uncertainty to impact business spending and lower hiring in the medium term.

Figure 2

Leading

Source: Eikon Reuters,

Uncertainty and firms’ investments

Empirical studies from the Bank of England found significant negative relationship between uncertainty and firm’s investments. For instance, Melolinna et al. (2018) found that the uncertainty, along with the cost of capital and macroeconomic fundamentals, has been an important driver of investment. The authors measure the uncertainty at a firm-specific level, which is the daily volatility in individual stock prices that cannot be explained by general market variation (CAPM model). Figure 3 (left frame) shows negative co-movement between uncertainty (HFM) and the UK business investment.

In another study, Smietanka et al. (2018) look at the macroeconomic uncertainty, which looks at the dispersion in surveys of professional forecasters. Figure 3 (right frame) also demonstrates a negative relationship between uncertainty (U) and the level of investment (dash line is a fitted line based on post-2008 sample).

Figure 3

Mel

Source: Melolinna et al. (2018), Smietanka et al. (2018)

Interesting risk premia for the long-run

Hence, the elevated uncertainty, combined with low consumption growth (consumption growth decreased from 0.9% annual prior the financial crisis to 0.3% post-Brexit) and a sluggish growth in the housing market are all going to weigh on the 3 to 6-month outlook, which may be reflected in asset prices. However, fundamentals in the UK have not deteriorated as in some of the European countries (i.e. France), and therefore we could expect an outperformance of UK assets relative to European ones. Figure 4 (left frame shows that the UK stock market appears cheap relative to the US and Europe.

Figure 4

Excess liquidity

Source: Bloomberg, Eikon Reuters, RR

What does it mean for the pound?

As we mentioned it in our latest FX Weekly, the British pound got strong support when it fell below the 1.25 level against the US dollar, therefore we think that buying Cable below that support could offer interesting returns for longer-term investors. As we expect the US dollar to weaken within the next 12 months (in our base scenario), currencies such as the euro and the pound could offset some of the USD weakness.

As we can see it in Figure 5, Cable is currently flirting with the 1.29 level, which corresponds to the 61.8% Fibo retracement of the 1.1975 – 1.4350 range and the 100-day SMA. A breakout of this area could lead us to the next retracement at 1.32. However, GBP may stabilize in the short term and therefore we think it could be interesting to play the crosses (long EURGBP and short GBPJPY). In addition, we can notice an interesting observation in figure 6, which shows the strong co-movement between GBPJPY and the world (ex-US) equities; we usually tend to look at AUDJPY as a proxy for risk-on / risk-off environment. Therefore, GBP could also be impacted by a small consolidation in the stock market.  

Figure 5

Cable

Source: Eikon Reuters

Figure 6

GBP and VEU

Source: Eikon Reuters

FX Cross-Currency Basis Swaps and Hedging Costs

One interesting topic in the FX market that has been closely studied by both academics and practitioners over the past decade is the violation of the covered interest parity (CIP). CIP is a textbook no-arbitrage condition that states that interest rate differential between two currencies should equal the differential between the forward and spot exchange rates. In other words, in discrete time, we have the following condition:

Where S is the spot exchange rate, F is the forward exchange rate, i is the domestic interest rate and i* is the foreign currency interest rate. The problem is that the above equation has held since the Great Financial Crisis; as it started to become more expensive to borrow US Dollars against most currencies during periods of stress, the cross-currency basis swap (CCBS) has been diverging from zero for the Euro, the British pound and the Japanese Yen. Figure 1 (left frame) shows the evolution of the 3-month CCBS for the three currencies (against the USD) since 2012.

Low interest rates combined with the significant divergence in unconventional monetary policies run by the BoJ and ECB over the years has put pressure on the exchange rates and the CCBS, and therefore has increased the hedging costs for Euro and Japanese investors. The current rate on the US 10Y Treasuries (3.15%) looks certainly very interesting for unhedged international investors (relative to domestic bonds such as in the Euro area or Japan), however changes drastically when we adjust for hedging costs. Figure 2 represents the cash-flows that occur at the start, during the term and at maturity when a Euro investor (A) enters a cross currency basis swap. As you can see, each quarter A pays the 3M USD Libor and receives the 3M Euribor and the basis. Hence, the more negative is the basis, the higher the hedging cost. With the 3M Euribor at -0.316%, the 3M CCBS at -44bps and the 3M Libor USD at 2.61%, the current return on a FX-hedged 10Y US Treasuries is negative (-20bps). Figure 1 (right frame) shows that despite the rise in US yields since the middle 2016, it has been falling for Euro and JPY investors after adjusting for FX hedging costs. A UK investor would get an annual return of 1.35%, which is 15bps below he can get in holding a 10Y Gilt.

Figure 1

Fig1.PNG

Source: Eikon Reuters

 

Figure 2

Fig2.png

Source: BIS

 

Great Chart: GBPUSD vs. FTSE 100

As we are closely approaching our 1.40 target for Cable (here), we chose an interesting chart this week that shows a scatter plot of the UK equity market (FTSE 100) with GBPUSD exchange rate, using a weekly frequency since January 2009.  Even though the relationship is not as clear as for Japan Equities and USDJPY (here), we can still observe a negative ‘Pavlovian‘ relationship where a cheaper currency usually implies higher equities. For instance, the British pound was massively sold post referendum (June 2016) on the back of an elevated political and economic uncertainty, high volatility and negative investors’ sentiment. Cable plunged from 1.44 a week before Brexit vote to reach a low of roughly 1.20 in October 2016 before starting its recovery in the first quarter of 2017.

One interesting observation is in the equity market; even though the FTSE 100 sold from 7,000 in April 2015 to 5,700 in February 2016 prior the event (as Cable), the post-Brexit rounds of Sterling depreciation played in favor of UK equities. However, over the past few months, the situation recovered in the UK, both the uncertainty and the volatility eased. If we look at the Economic and Political Uncertainty index, a monthly series based on newspaper coverage developed by Baker, Bloom and Davis, it is down from almost 1,200 (summer 2016) to 200, its prior Brexit average, bringing Cable’s 1M ATM implied volatility from 19 to 7.85 (here). At the same time, the 3-month 25 Delta Risk Reversal is back into the positive territory (from -6 in June / July 2016), meaning that the implied volatility on calls is more expensive than puts (here).

With an equity market closing at 7,730 on Friday and Cable at 1.3850 (flirting with the 1.39), we are curious to see if the relationship will continue this year. Hence the question is: will the Footsie break its 8,000 psychological resistance while Cable continues its momentum?

Our view is that the Bank of England may surprise the market in 2018 concerning its interest rate path. With the December 2019 short-sterling futures contract trading at 98.88 (i.e. implied rate of 1.12 by the end of 2019), market participants are currently pricing in two hikes for the next couple of years. We think that three to four hikes is more appropriate to the current economic climate, and policymakers may send a signal in the February update of its inflation forecasts, triggering some moves in the short-term interest rate market. We think that a potential move in the forward IR curves will benefit to the Sterling pound, however equities may struggle to reach new highs and break above the 8,000 level.

Chart: Cable vs. FTSE 100 (Source: Reuters Eikon)

Great Chart: TOPIX vs. USDJPY

As we always like to look at the Japanese Yen charts (USDJPY, AUDJPY, MXNJPY) as a sort of alternative barometer of investors sentiment and overall financial conditions, we chose an interesting chart this week that shows a scatter plot of the Japanese equity market (TOPIX) with USDJPY. The two assets have shown a significant relationship over the years, especially since Abe took office in Q4 2012 and the BoJ introduced QQME (i.e. extremely accommodative monetary policy) on April 3rd 2013. Investor Kyle Bass was one of the first to introduce the term Pavlovian response to this ‘weaker yen, higher equities’ relationship in Japan, which brought a lot of ‘macro tourists’ instead of long-term investors.

However, we noticed that the relationship between the Yen and the TOPIX broke down in Q2 2017. While the Japanese equity market has continued to soar over the past few months, currently flirting with the 1,900 psychological level (its highest level since 1991), USDJPY has been less trendy and has been ranging between 107 and 114 (see divergence here). Hence, we decided to plot a scatter chart between the two assets using a weekly frequency since 2001.

As you can see, a strong Japanese Yen (i.e. USDJPY below 100) usually goes in pair with a weak equity market. For instance, we barely see the TOPIX index above 1,000 when the USDJPY trades below the psychological 100 level. However, as the exchange rate increases, we see more dispersion around the upward sloping linear trend; for a spot rate of 120, we had times when the TOPIX was trading at 800 and other times when it was trading at 1,800. We did a simple exercise and regress the exchange rate returns on the equity returns (both log terms) to see if we get some significant results, using the following equation:

As you can see, the coefficient Beta is economically and statistically significant at a 1-percent level. Using 16 years of data, we find that a 1-percent increase in USDJPY spot rate is associated with a 0.76% increase in the stock market.

We highlighted the point where we currently are in the chart (Today), which is a TOPIX at 1,889, its highest level in the sample, for a USDJPY spot rate of 112.80. We can notice that the point is located at an extreme level of dispersion, and the question we raised a few weeks ago was ‘Can the divergence between the equity index and the exchange rate continue for a while?’

We think that the stock market in Japan will struggle to reach new highs and generate some potential interesting returns in the months to come due to the poor performance of the banking system (strong weigh in the index) and the constant decrease in the effectiveness of the BoJ policy measures. We mentioned a month ago that the Japanese Yen was 26% ‘undervalued’ relative to its 23Y average value of 99.3 according to the Real Effective Exchange Rate (REER valuation) (see here), hence we find it difficult to imagine a super bear JPY / Bull TOPIX scenario. In addition, we also raised the fact that the current level of oil prices were going to deteriorate Japan Trade Balance in the future (see here), pushing back the current account in the negative territory and potentially impacting the stock market.

Chart: Scatter plot of TOPIX vs. USDJPY – weekly frequency (Source: Reuters Eikon) 

Great Chart: Cable vs. 2Y UK – US IR Differential

As for EURUSD and the 10Y interest rate (IR) spread (here) or for USDJPY versus the equity market (TOPIX, see here), the same interesting divergence has been occurring between Cable and the 2Y IR differential. We mentioned in many of our posts that the interest rate differential (either short term 2Y or long term 10Y) has been considered as one of the main drivers of a currency pair for a long time. For instance, in our BEER FX Model, we used the terms-of-trades, inflation and the 10-year interest rates differentials for our cross-sectional study, using the US Dollar as the base country and currency (see post here).

Hence, if you look back over the past few years, there is a significant co-movement between the two times series. As you know, the ST 2Y IR differential reflects the expected announcements from either UK or US policymakers concerning the future path of the target IR set by the central bank. For instance, between summer 2013 (when Governor Carney took office at the BoE) and summer 2014, the 2Y IR differential went up from 0 to 45bps on the back of strong UK fundamentals (fastest growing economy in G7 in 2014) and market participants starting to price in a rate hike as early as Q4 2014 or Q1 2015 according to the short-sterling futures contract (see July 2014 update). The increase of both the 2Y IR differential and the short-sterling futures implied rate brought Cable to its highest level since October 2008 at 1.72 in July 2014. However, both trends reversed that summer with the US Dollar waking up from its LT coma and the UK starting to show some weaknesses in its fundamentals. At that time, we entered a 2Y+ Cable bear market, and if we omit the pound ‘flash crash’ in early October 2016 and set the low at 1.20, Cable experienced a 30-percent depreciation. Therefore, this fall moved the British pound from being a slightly overvalued currency to a clearly undervalued currency if we look at some broad measures such as the real effective exchange rate (REER). According to the REER, the Pound is 15% far away from its 23Y LT average (GBP REER).

If we look at the last quarter of 2017, despite a 50bps drop in the 2Y differential (currently trading at -1.44%), Cable found support slightly below its 100D SMA each time and the pair has shown strong momentum since the beginning of the year. We believe that the strong decrease in the IR differential lately comes from an (over) confident market pricing in three Fed hikes next year (probability of 4 or more rate hikes stands at 9% in 2018). However, we think that this current excitement may slow down in Q1 2018, hence readjust the IR differentials, which is going to be positive for the British pound against the greenback. In our view, the 1.40 level seems reasonable for Cable in the medium term (1-3M), which corresponds to the 38.2% Fibonacci retracement of the 1.20 – 1.72 range.

Chart: GBPUSD vs. 2Y IR differential (blue line, rhs) Source: Reuters Eikon

Cablevs2Y.PNG

Monetary Policy Coordination: From Global Easing to Global ‘Tightening’

Abstract: An interesting series of central-bank announcements over the past semester confirmed our view of a global central banking monetary policy coordination. The first two major players that hinted in a speech that the central bank might slow down their asset purchases were the ECB and the BoJ; but more recently we heard hawkish comments coming from the BoC, RBA and even the BoE. In this article, we first review the quantitative tightening (or the Fed balance sheet reduction program), followed by some comments on the current situation in the other major central banks combined with an FX analysis.

Link ==> US Dollar Analysis 2

FX positioning ahead of the September FOMC meeting

As of today, most market participants are getting prepared [and positioned] for the FOMC meeting on September 20/21st in order to see if policymakers stick with their Jackson-Hole hints, therefore we think it is a good time to share our current FX positioning.

Fed’s meeting: hike or no-hike?

We think that one important point investors were trying to figure out the last Jackson Hole Summit last week was to know if US policymakers were considering starting [again] their monetary policy tightening cycle after a [almost] 1-year halt. If we look at the FedWatch Tool available in CME Group website, the probability of a 25bps rate hike in September stands now at 18% based on a 30-day Fed Fund futures price of 99.58 (current contract October 2016, implied rate is 42bps).

CME.png

(Source: CME Group)

In addition, if we look at the Eurodollar futures market, the December Contract trades at 99.08, meaning the market is pricing a 1% US Dollar rate by the end of the year. We can clearly notice that the market expects some action coming from US policymakers within the next few months. However, recent macroeconomic data have shown signs of deterioration in the US that could potentially put the rate hike on hold for another few months. Following last week disappointing manufacturing ISM data that came out at 49.4 below its expansion level (50), ISM Service dropped to 51.4, its lowest number since February 2010 and has been dramatically declining since mid-2015. We strongly believe that there are both important indicators to watch, especially when they are flirting with the expansion/recession 50-level. We can see in the chart below that the ISM manufacturing PMI (white line) tracks really ‘well’ the US Real GDP (Annual YoY, yellow line), and as equity markets tend to do poorly in periods of recession we can say that the ISM Manufacturing / Services can potentially predict sharp drawdowns in equities.

Chart 1. ISM – blue and white – and Real US GDP Annual YoY – yellow line (Source: Bloomberg)

ISM_US.JPG

Another disappointment came from the Job market with Non-Farm Payrolls dropping back below the 200K level (it came out at 151K for August vs. 180K expected) and slower earnings growth (average hourly earnings increased by 2.4% YoY in August, lower than the previous month’s annual pace of 2.7%).

This accumulation of poor macro figures halted the US Dollar gains we saw during the J-Hole Summit and it seems that the market is starting to become more reluctant to a rate hike in September. The Dollar Index (DXY) is trading back below 95 and the 10-year rate is on its way to hit its mid-August 1.50% support (currently trades at 1.54%). What is interesting to analyse is which currency will benefit most from this new Dollar Weakness episode.

FX positioning

USDJPY: After hitting a high of 104.32 on Friday, the pair is once again poised to retest its 100 psychological support in the next few days. This is clearly a nightmare for Abe and Kuroda as the Yen has strengthen by almost 20% since its high last June (125.85). If we have a look at the chart below, the trend looks clearly bearish at the moment and longs should consider putting a tight top at 105. we would stay short USDJPY as we don’t see any aggressive response from the BoJ until the next MP meeting on September 21st.

Chart 2. USDJPY candlesticks (Source: Bloomberg)

EURUSD: Another interesting move today is the EURUSD 100-SMA break out, the pair is currently trading at 1.1240 and remains on its one-year range 1.05 – 1.15. As a few articles pointed out recently, the ECB has been active in the market since March 2015 and has purchased over 1 trillion government and corporate bonds. The balance sheet total assets now totals 3.3 trillion Euros (versus 4 trillion EUR for the Fed), an indicator to watch as further easing announced by Draghi will tend to weigh on the Euro in the long run. The ECB meets in Frankfurt on Thursday and the market expect an extension of the asset purchases beyond March 2017 (by 6 to 9 months). We don’t see a further rate cut (to -0.5%) or a boost in the asset purchase program for the moment, therefore we don’t think we will see a lot of volatility in the coming days. we wouldn’t take an important position in the Euro, however we can see EURUSD trading above 1.13 by Thursday noon.

Chart 3. EURUSD and Fibonacci retracements (Source: Bloomberg)

Another important factor EU policymakers will have to deal with in the future is lower growth and inflation expectations. The 2017 GDP growth expectation decreased to 1.20% (vs. 1.70% in the beginning of the year) and the 5y/5y forward inflation expectation rate is still far below the 2-percent target (it stands currently at 1.66% according to FRED).

Sterling Pound: New Trend, New Friend? The currency that raised traders’ interest over the past couple of weeks has been the British pound as it was considered oversold according to many market participants. Cable is up 5% since its August low (1.2866) and is approaching its 1.35 resistance. We would try to short some as we think many traders will try to lock in their profit soon which could slow down the Pound appetite in the next few days. If 1.35 doesn’t hold, then it may be interesting to play to break out with a new target at 1.3600.

Chart 4. GBPUSD and its 1.35 resistance (Source: Bloomberg)

GBP.JPG

We would short some (GBPUSD) with a tight stop loss at 1.3520 and a target at 1.3350. No action expected from the BoE on September 15th, Carney is giving the UK markets some ‘digestion’ time after the recent action (rate cut + QE).

USDCHF: For the Swissie, our analysis stands close to the Yen’s one, and therefore we think the Swiss Franc strength could continue in the coming days. we like 0.96 as a first ‘shy’ target, and we would look at the 0.9550 level if the situation remains similar (poor macro and quiet vol) in the short term.

AUDUSD: Australia, as many other commodity countries (Canada, New Zealand), remains in a difficult situation as the deterioration of the terms of trade will tend to force RBA policymakers to move towards a ZIRP policy. However, lower rates will continue to inflate housing prices, which continue to grow at a two-digit rate. According to CoreLogic, house prices averaged 10-percent growth over the past year, with Sydney and Melbourne up 13% and 13.9%, respectively. Australian citizens are now leverage more than ever; the Household debt-to-GDP increased from 70% in the beginning of the century to 125% in Q4 2015 (see chart below). This is clearly unsustainable over the long-run, which obviously deprives policymakers to lower rates too ‘quickly’ to counter disinflation. As expected, the RBA left its cash rate steady at 1.50% today, which will play in favor of the Aussie in the next couple of weeks. One interesting point as well is that the Aussie didn’t react to an interest rate cut on August 2nd, something that Governor Glenn Stevens will have to study in case policymakers want to weaken the currency. There is still room on the upside for AUDUSD, first level stands at 0.7750.

Australia.png

(Source: Trading Economics)

Chinese Yuan: The Renminbi has been pretty shy over the past two month, USDCNH has been ranging between 6.62 and 6.72. The onshore – offshore spread is now close to zero as you can see it on the chart below (chart on the bottom). We don’t see any volatility rising in the next few weeks, therefore we wouldn’t build a position in that particular currency.

Chart 5. CNY – CNH spread analysis (Source: Bloomberg)

CNH spread.JPG

 To conclude, we think that we are going to see further dollar weakness ahead of the FOMC September meeting as practitioners will start to [re]consider a rate hike this time, especially if fundamentals keep being poor in the near future.

Japan: Flirting with Helicopter Money

As we already mentioned in a few articles, the Yen strength over the past year was going to be a problem somehow for PM Abe and the BoJ. After reaching a high of 125.86 in the beginning of June last year, USDJPY has entered into a bearish trend since last summer [2015] with the Yen constantly appreciating on the back of disappointments coming from the BoJ (i.e. no more QE expansion). The pair reached a low of 99 post-Brexit, down by 21.3% from peak to trough, sending the equities down below 15,000 (a 30% drawdown from June high of 21,000). The plunge in the stock market was directly reflected in the performance of the Japanese pension and mutual funds; for instance, the USD 1.4 trillion GPIF lost more than USD 50bn for the 12 months through March 2016 (end of the fiscal year). The Fund, as the graph shows below (Source: GPIF) , has been selling its JGBs to the BoJ over the past few years due to Abenomics (the allocation declined from 67.4% in 2011 to 37.8% in 2015) and has mainly been increasing its allocation in domestic and international stocks. With more than USD 13 trillion of sovereign bonds trading at a negative yield – the Japan Yield Curve negative up to 15 years – you clearly understand why we am always saying that Abe and the BoJ cannot lose against the equity market.

A the situation was getting even worse post-Brexit, with the Yen about to retest its key 100-level against the US Dollar, the Yen weakness halted suddenly on rumours of potential ‘Helicopter Money’ on the agenda.

It started when Reuters reported that former Fed chairman Bernanke was going to meet PM Abe and BoJ Kuroda in Tokyo to discuss Brexit and BoJ’s current negative interest rate policy. However, market participants started to price in a new move from the BoJ – i.e. Helicopter Money, a term coined by American economist Milton Friedman in 1969. In his paper ‘The Optimum Quantity of Money’, he wrote:

‘Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.’

In short, Helicopter Money is a way of stimulate the economy and generate some inflation by directly transferring money to the nation’s citizens. This money, as a contrary of refinancing operations or QE, will never be reimbursed.

Buy the rumors, sell the fact?

The effect on the currency was immediate, and USDJPY soared from 100 to [almost] 107 in the past 12 years, levitating equities as you can see it on the chart below (SP500 in yellow line overlaid with USDJPY candlesticks). It was confirmed that on the week ending July 15th, the Yen had his biggest drop in the 21st century. The SP500 index reached its all-time high of 2,175 today and in our opinion, the Yen weakness is the best explanation to equities testing new highs in the US.

(Source: Bloomberg)

Talking with Bernanke: Conversations and Rumors

As the meeting was held in private, we don’t have any detail on the conversation. On common sense, you would first think that the discussion would be on the potential BoJ retreat from the market as its figures are starting to be really concerning (35% of JGBs ownership, 55% of the country’s ETF, 85% total-assets-to-GDP ratio). It is clear that the BoJ cannot continue the 80-trillion-yen program forever, and from what we see in Japan [markets or fundamentals], the effectiveness of monetary policy is gone.

However, it looks to me that market participants are convinced that the BoJ will act further, which is to say adopt a new measure. This was clearly reflected in the currency move we saw, and they [better] come with something in the near future if Japan officials don’t want to see a Yen at 95 against the greenback. The next monetary policy meeting is on July 29th, an event to watch.

Introducing Helicopter Money

We run into a series of really nice and interesting articles over the past couple of weeks, and we will first start by introducing this chart from Jefferies that summarizes the different schemes of Helicopter Money very well.

chopper money schematic

We were only aware of the first scheme, where the central bank directly sends money to the households or directly underwrites JGBs. However, as Goldman noted, the second popular scheme would be to convert all the JGBs purchased by the BoJ on the secondary market into zero-coupon perpetual bonds. When you think that a quarter of Japan revenues from tax (and stamps) are used to service debt with the BoJ running out of inventories (i.e. JGBs) to buy, the second scheme makes a lot of sense in fact.

The other part that Goldman covered was on the legal and historical side. As the picture below (Source: Jefferies) shows you, Article 5 of Japan’s Public Finance Law ‘prohibits the BoJ from underwriting any public bonds’. However, under special circumstances, the BoJ may act so within limits approved by a Diet resolution. In other words, the BoJ can underwrite public bonds. The only problem is once Helicopter Money is adopted, it is difficult to stop it. Japan already ‘experienced helicopter money’ in the 1930s after it abandoned the gold standard on December 13th 1931. It first devalued the Yen by 40% in 1932 and 1933, and then engaged in large government deficit spending to stimulate its economy; it was called the Takahashi fiscal expansion (Japan FinMin, Takahashi Korekiyo, also referred as the Japanese ‘Keynes’). As Mark Metzler described in Lever of Empire: The International Gold Standard and the Crisis of Liberalism in Prewar Japan (2006), ‘increased government spending was funded by direct creation of money by the BoJ’.

helicopter primer 2

It was not until 1935 that inflation start rising, and the expansionary policies of Takahashi’s successor after the FinMin assassination in 1936 led the country to a balance of payments crisis and hyper-inflation.

‘Be careful what you wish for’.

In our opinion, as central banks shouldn’t be too focus on the currency, an interesting way of stimulating an economy would be by transferring money directly to citizens’ account. The BoJ could put a maturity date to the money they transfer (i.e. the citizen has one year maximum to spend the money he received), and ‘obliged’ their citizens to spend it on Japanese goods, therefore stimulating the internal demand and eventually leading to a positive feedback loop.

The announcement of additional measures from Japan in the near future should continue to weigh on the Yen, and USDJPY could easily re-reach 110 quite quickly if rumors become more and more real.