Implied volatility on the Japanese yen has been surging in recent weeks following BoJ dovish comments last month. Not only the BoJ has not expressed any interest in normalizing its policy despite the surge in inflation globally, the central bank recently offered to buy an unlimited amount of 10Y JGBs at 0.25% to limit the upside retracement in LT bond yields. As a result, the strong divergence in monetary policy between BoJ and other DM central banks (particularly the Fed) has led to a significant rise in USDJPY.
USDJPY broke above its 125.80 resistance (the high reached in 2015) to reach a high at 129.37 on Tuesday, and is now the worst performing currency among the DM world, down over 10% against the greenback since the start of the year.
JPY is now the most undervalued currency among the G10 world, currently trading 21.3% below its ‘fundamental’ value, which is estimated based on a BEER FX model using the terms of trade, interest rate and inflation differentials as explanatory variables.
Even though the yen appears as a ‘cheap’ currency to buy at the moment, MP divergence could continue to weigh on JPY in the near term. In the past cycle, the last two bullish trends on USDJPY driven by strong MP divergence saw an upward retracement of 20 to 25 figures. Hence, USDJPY could increase to at least 135 (start of the trend at 115), which represents a strong resistance (135 was the high reached in February 2002).
In the past few months, the strong deceleration in the Chinese economic activity combined with the sharp contraction in ‘liquidity’ (Total Social Financing 12M Sum YoY change) have been weighing on the Aussie against major crosses. After peaking at 0.80 in February against the USD, the Aussie has been constantly testing new lows and is now down nearly 10% against the greenback.
AUD is now the most undervalued (-15%) currency among the G10 world according to our BEER model, which uses terms of trade, inflation and 10Y interest rate differentials as explanatory variables to compute the ‘fair’ value of currencies.
The second most undervalued currency is ‘risk-on’ GBP, standing at -13.2% from its ‘fair’ value. The rise in volatility combined with the deceleration in global liquidity have been weighing on Sterling in recent months.
On the other hand, the CHF is the most overvalued currencies against the USD (+7.7%) according to our BEER model, followed by the EUR (+3.8%). It is interesting to see that the Euro, which appears significantly undervalued from a PPP approach (PPP estimates the ‘fair’ value of EURUSD at 1.41 – implying that the EUR is over 18% undervalued), is now overvalued using a BEER approach.
We know that Sterling has historically traded like a risk-on currency that tends to appreciate in periods of trending markets and consolidate sharply in high-volatility regime.
Figure 1 shows the monthly average performance of the most liquid currencies relative to the dollar when the VIX rises above 20 in the past 30 years. As expected, the yen is the currency that benefits the most when price volatility rises, averaging 45bps in monthly returns. On the other hand, the pound has averaged -30bps in monthly returns when the VIX was high.
This was confirmed during the March 2020 panic as GBP was sold aggressively during that month with Cable reaching a low of 1.14 (down from 1.32 in early March) before starting to recover gradually (lowest level since 1985).
Figure 2 shows an interesting relationship between GBPUSD and mega-cap growth stocks since 2020 (FANG+ stocks); Sterling has significantly recovered in the past 17 months, up nearly 20% against the US Dollar. However, the momentum on Cable has halted in recent months as risky assets have shown some signs of ‘fatigue’ amid rising uncertainty over a range of risk factors (i.e. Delta variant, falling growth expectations…).
As we mentioned it in one of our previous posts, there has been a strong co-movement between the US Dollar and the 2Y10Y yield curve in the past 15 years, but the relationship was potentially going to break out as the US dollar was getting extremely oversold while inflation expectations have been constantly rising in the past few months (usually leading to yield curve steepening). This chart shows that while the the USD index has stabilized at around 90-91 since the start of the year, the 2Y10Y yield curve has steepened sharply by 45bps to 1.25%.
In the past few months, demand for gold has been falling amid rising optimism over the vaccination campaign and the reopening of the economy. However, two major drivers are still pricing in further upside gains in the near to medium term.
First, we saw that as inflation expectations have been rising sharply in the past few months, US real yields have continued to reach new lows and are currently pricing in higher gold prices in the short run. Figure 1 shows that the 5Y US real interest rate have co-moved strongly with gold prices in the past cycle; the 5Y real rate is currently trading at -1.81% and is pricing in a ounce of gold above the $2,000 level.
The second driver is the total amount of negative-yielding debt in the market, which could also be seen as an indicator of market stress. Interestingly, figure 2 shows that gold prices seem to have followed the recent decrease in the amount of debt yielding below 0 percent; after remaining to an all-time high above 18tr USD in the beginning of the year, the total amount of negative-yielding debt has recently decreased to 16tr USD.
However, the most important driver of gold in the medium term remains the annual change in global liquidity, which we compute as total assets of the 5 major central banks (Fed, ECB, BoJ, PBoC and BoE). Figure 3 shows that gold prices have co-moved strongly with the annual change in global liquidity in the past cycle; hence, when the market realizes that social distancing norms and travel restrictions are going to remain elevated longer than participants currently expect, gold prices should experience another significant rally.
In the past few weeks, we have noticed that the ‘Short Dollar Trade’ has remained very crowded despite the positive bounce in the USD in January. According to the CFTC, total amount of net shorts is still standing at 257K contracts, a short USD position that is mainly concentrated against the Euro (165K contracts). Even though some investors argue that the CFTC CoT only shows a minor picture of the daily 5-trillion USD OTC FX market, it is still interesting to know the dynamics in the standardized market, especially when the positioning are standing at extreme levels.
We think that the rise of uncertainty in 2021 amid elevated restrictions and travel bans between ‘high-risk’ countries may increase demand for traditional safe such as the greenback and that the lack of economic activity in the Euro area could lead to a rise in political uncertainty, which should weigh on the single currency in the near to medium term. Figure 2 (right frame) shows that rising uncertainty has historically led to a higher Dollar against most currencies.
It is interesting to see that while the Brazilian Real has remained weak against the USD in the past 9 months, the Mexican Peso has strengthened significantly (MXN is up over 25% since its low reached in the beginning of April).
What happens to Mexico in 2021? As Brazil, the country has been deeply impacted by the pandemic, and the vaccination campaign has been running very slow (0.5 doses given per 100 people), which could lead to travel bans with some countries where the vaccination campaign has been much faster (US, UK…). With the tourism industry representing 17.5% of the country’s GDP, political and economic uncertainty is very likely to rise in the coming months, which could lead to significant MXN depreciation.
The upside gain on MXN remains very limited, while the downside risk is big; watch the USDMXN rally (i.e. MXN fall) this year !
While the Fed is expected to purchase 240bn USD of Treasuries each quarter in 2021, net Treasury supply is estimated to be significantly higher at around 600bn USD per quarter (2.5 times higher); and this does not even include the recent 1.9tr USD Biden proposal. Even if the Biden administration does not end up being as aggressive as initially proposed, even a 1-trillion-dollar ‘stimulus’ program will significantly increase the divergence between net Treasury issuance and net Fed purchases.
What will happen to US interest rates in 2021? On one hand, we know that long-term interest rates cannot rise too much from current levels as a significant (upside) move in the 10Y yield could end up having a dramatic impact on the equity and/or corporate bond markets. On the other hand, if the Fed goes ‘all in’ and matches 1-to-1 the net issuance of US Treasuries as they did in 2020, other central banks (i.e. ECB, BoJ) will have no other choice than to fight the USD depreciation as policymakers will certainly not let their currency appreciate indefinitely.
In the past 15 years, we have seen that the dynamics of the exchange rate in Japan (JPY) has had a significant impact on equities; it has been described as a negative ‘Pavlovian’ relationship where a cheaper currency has usually been associated with higher equities. This chart shows the significant co-movement between Japanese equities – TOPIX – and the USDJPY exchange rate; hence, we are confident that policymakers in Japan are strongly aware of that relationship and therefore the BoJ is carefully and constantly watching the exchange rate.
It is interesting to see while the Japanese Yen has been constantly appreciating against the US Dollar amid the aggressive liquidity injections from the Fed (relative to BoJ), equities have strongly recovered from their March lows and are currently trading at their highest level since October 2018. However, we do not think that this relationship will persist in the medium term; as we previously mentioned, a strong Yen will not only dramatically impact the economic ‘recovery’ but also weigh on LT inflation expectations. The last time the relationship broke down between the two times series was in the beginning of 2018, with the TOPIX rising to nearly 1900 while the Yen was gradually strengthening against the USD, but it did not take long for equities to converge back to their ‘fair’ value.
We are not suggesting that trend in equities is about to revert, but investors should be careful as the ‘Short USD / Long The Rest’ trade has become very crowded.
Despite the 13% fall since March, investors’ sentiment on the USD is still extremely negative for 2021. We previously argued that central banks (ex-Fed) will not let the greenback depreciate indefinitely as it will dramatically impact the economic ‘recovery’ (i.e. Euro area is very sensitive to a strong exchange rate) and weigh on long-term inflation expectations. In addition, figure 1 shows that a weaker US Dollar has coincided with a positive momentum in equities in recent years, especially since the February/March panic; therefore, being long US Dollar at current levels could offer investors a hedge against a sudden reversal in risky assets in the short term.
Another interesting observation comes out when we look at the seasonality of the USD in the past 50 years; while December tends to be the worst month on average for the greenback, January has historically been the best performing month with the Dollar averaging nearly 1% in monthly returns since January 1971.
Is it time for a ST bull retracement on the US Dollar?