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: SP500 vs. US 2Y10Y Yield Curve

Historically, research has shown that the difference between long-term and short-term interest rates (‘Yield Curve’ or ‘Time Spread’) has shown some significant negative relationship with subsequent real economic activity in the United States, with a lead of about four to six quarters. Hence, with the current low levels of the US yield curves (2Y10Y or 5Y30Y), we chose today this week to overlay the 2Y10Y yield curve with the SP500.

If we say that low yield curves tend to predict recessions, then the question now relies on quantifying a low level of the yield curve. We hear from many analysts that the current levels are very low, however if we look back at 40 years of data, the US yield curve levels are not that far away from their long-term averages. For instance, the 2Y10Y and 5Y30Y slopes are currently trading at 51bps and 53bps, while their LT averages stand at 95bps and 82bps, respectively (see here). One main reason why yield curves have been crashing over the past few months is mainly due to an increase in the front-end of the US curve on a back of a shift in expectations of monetary policy. The US 2Y interest rate is now trading at 1.96%, its highest level since September 2008. On the other hand, the 10Y yield stands at 2.46%, has been ranging between 2% and 2.6% over the past year and is up 110bps from its historical low of 1.36% reached in July 2016.

The chart below shows the importance that even if the yield curve turns negative in the US, the equity market has still upside potential in the following months. In our first observation, the 2Y10Y time spread went negative in February 2000, while the SP500 continued its rally and reached a peak in September the same year. In the second one, the yield curve inverted in June 2006 (if we ignore the Jan-Mar 2006 episode) while equities continued to rise for more than a year, peaked in October 2007, and the US plunged into the Great Depression in December 2007.

We don’t think that the current levels of the yield curves are actually alarming for the US economy and we may see a potential floor in the first quarter of this year as we believe that market participants’ (over)excitement on the Fed potential hikes will ease in the medium term. The probability of 4 or more hikes has soared to 12.1%, which pushed the front end of the US curve on the upside and explains the sharp flattening we saw in 2017 (from 1.27% to 0.5%). However, if we look at the EuroDollar futures market, the December 2018 contract currently trades at 97.81, suggesting that investors are pricing in a ST interest rate of 2.19% by the end of the year (see here). This analysis also confirms our bearish view on the US Dollar for 2018 (especially against the Euro).

Chart: SP500 (yellow, rhs) vs. US 2Y10Y Yield Curve (Source: Reuters Eikon)

Yield Curve.PNG

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

Great Chart: US 2Y10Y yield curve vs. USDJPY

Among all the potential compatible candidates that show an interesting correlation vis-à-vis the USDJPY (i.e. 10-year US-Japan interest rate differential, Topix index …), I chose this week to overlay the currency pair with the US 2Y10Y yield curve. If we look at the past three years of data, we can notice an interesting development that has started since mid-April of this year. While the US yield curve and USDJY has shown strong co movement between January 2015 and April 2017, it has been a different story over the past 8 months.

In the US, the yield curve has constantly been falling and is currently trading at 51.5bps half the value where it was sitting in April 2017. On the other hand, the Japanese Yen has been oscillating within a 7-figure against the green back, between 107.50 and 114.50. What is interesting about this divergence is that it started more or less at the same time of the Topix vs. USDJPY divergence, with Japanese equities soaring from 1,500 to 1,800 and a Yen mean reverting around 111 against the USD ( see tweet Topix vs. USDJPY).

The question now is: How long can this divergence persist in the near to medium term? The current level of the US yield curve has raised the concern of many market participants as in theory it is viewed as a strong predictor of future recessions. Looking at economic and financial data, I don’t personally believe that we are very close to a potential recession in the US; in addition, the yield curve is still far from its extreme lows of -20bps and -95bps we saw in November 2006 and May 2000 (if we just look at the past 30 years of data). However, I think that we may see some US Dollar weakness against the Japanese Yen, on a back of slowly disappointing fundamentals (easing all the excitement on the expected Fed rate hikes) and geopolitical uncertainty. Moreover, the Japanese Yen is 26% ‘undervalued’ relative to its 23Y average of 99.3 according to the real effective exchange rate ( see JPY REER).

Chart: USDJPY (Candlesticks, rhs) vs. US 2Y10Y yield curve (Source: Bloomberg)

JPY US Curve

FX Technical Analysis

This page aims to provide the major technical indicators used in Finance, and especially in the Foreign Exchange market. In addition to define the several steps to compute each specific indicator, we describe a potential systematic (and tactical) strategy applied to currencies and also provide an Excel File (with VBA macros). Hence, readers are able to see how those technical indicators are built, and then can backtest a few strategies on exchange rates using their own parameters.

We chose to first start with the major indicators used by market participants: there are the Moving Average (Simple and Exponential), the Relative Strength Index (RSI), the Moving Average Convergence Divergence (MACD) and the Bollinger Bands.

  1. Link to Momentum Indicators ===> TA_Momentum
  2. Link to Reversal Indicators ===> TA_Reversals
  3. Link to Excel File ===> TechnicalAnalysis_Indicators

Figure 1. Performance of a L/S Portfolio using EMA(5,20) on USD/AUD

Performance.PNG

The History of the Australian Dollar (Aussie)

In today’s article, we continue our series on the History of Currencies, with a particular focus on the popular carry-trade currency: the Australian Dollar. According to the BIS Foreign Exchange Turnover, the Aussie stands at the 5th position (straight after the British pound) in terms of volume with a daily average of 348 billion US Dollars (which represents 6.9% in percentage shares of average daily turnover).

This article is organized as follows. In the first section, we quickly introduce some important historical events for Australia and its currency. In section 2, we explain the trends and reversals of the Australian Dollar (versus. USD) since the end of the Bretton Woods system in addition to stating the main potential drivers of the currency pair. In Section 3, we quickly present a few [practical] charts using the Aussie for our case study.

I. Important events in Australia and the history of the Aussie until the end of the Bretton Wood System (1971)

A. Origins and History

From being the land of the indigenous Australians (60,000 years ago) to becoming a Federal Constitution on January 1st 1901, Australia attracted the interest of many conquerors. But the two main European explorers were the Dutch (Willem Janszoon, 1606) and the British (James Cook, 1770).

Despite the first European settlement taking pace in the late 1788 at Port Jackson in New South Wales (Sydney today), the latter colony experienced money shortage for the next three decades as the British [Empire] was challenged by France under Napoleon, investing large amounts of capital and resources to win. Hence, the mean of exchange (what today could be called ‘Store of Value’ or ‘Reserves’) during that period was Rum.

Then, the first coinage issuance happened in 1813, after Lachlan Macquarie (Governor of New South Wales) took the initiative of using 10,000 British pounds worth of Spanish Dollars received by the British government. The plan, that took a year to complete, was to convert the 40 thousand imported coins to 39,910 holey dollars (coins with a hole inside) and 39,910 dumps. Then, in 1817, the Bank of New South Wales (first bank in Australia) was established to provide economic stability for the citizens of the state, and started to issue paper currency.

Eventually, Sterling coinage was introduced in 1825 in all British colonies as a result of the Coinage Act 1816 (British Gold Standard) and the decline in the supply in Spanish dollars due to Latin American wars of independence, and the Holey dollar went out of circulation in the late 1820s (no longer legal tender in 1829). Due to a large increase in the population, and a rejection from Britain to the requests from Australian colonies to make gold coins, unofficial gold coins were used during the Victorian gold rush of the 1850s. Then, in 1855, Australia’s first official mint was established in Sydney, and started to produce gold coins called sovereigns (worth 1£), half sovereign and private bank notes.

B. Australian Pound, Gold Standard and WWI

After the Federation in 1901, Australia started to prepare for a national currency as the government started to realize the importance of a stable currency regime. Hence, in 1910, the Australian pound was born, consisting of 20 shillings. As the Australian pound was pegged to the British pound, Australia was therefore on a Gold Standard. If we look at the bilateral exchange rate against the US Dollar, we know from Figure 1 that the British Pound was roughly worth 5 units of USD, hence the USD/AUD exchange rate at that time was fixed at $5.

In 1914, Britain temporally exited from the Gold Standard as a consequence of WWI, creating inflation pressures, but returned to it in 1925 at the parity. As the exchange rates (both the British and Australian Pound) devaluated during and after the War, the sharp revaluation of the two currencies reduced exports drastically and raised deflationary waves resulting in both an increase in the unemployment rate and a contraction in productivity (See Australia Terms of Trade history in Figure 2 (Gillitzer and Kearns, 2005)).

Australia left the Gold Standard in 1929 due to the Great Depression and started a series of devaluation against the Sterling pound. All we know is that in December 1931, a Sterling pound was then worth 1.5 Australian pound. Between 1929 and 1932, the sharp contraction of the terms of trade as a result of a fall in commodity prices severely impacted the Australian economy. The unemployment rate soared to over 20 percent in the early 1930s (Figure 4), leaving hundreds of thousands of Australians out of work, and the country’s national income declined by 30 percent.

The devaluation of the currency and the improvement of major trading partners’ economies (United Kingdom and US) led to a slow recovery, with improvement in the Balance of Payment and an unemployment rate slowly converging to its long-term mean (5 percent) thanks to an explosion in the manufacturing sector.

C. World War II and Bretton Woods period

As we described in our article History of the British Pound, an agreement between the US and UK pegged the Sterling pound to the US Dollar at a rate of $4.03 in 1940. That exchange rate remained fixed after the start of Bretton Woods agreement in 1944, but UK Chancellor of the Exchequer Sir Stafford Cripps announced a 30-percent devaluation from $4.03 to $2.80 in September 1949. At the same time, Australian Prime Minister Ben Chifley followed the British move and devalued the Australian pound from $3.224 to $2.24 in order to not experience an over-valued currency relative to its Sterling zone countries. That means during all that period (before and after the devaluation), the Australian pound was worth 1.25 per unit of Sterling pound.

D. The Birth of the Australian Dollar (and the RBA)

After several names suggestions for the currency (i.e. royal, austral, koala, digger…), the Australian pound was eventually replaced by the Australian Dollar in 1966 (February 14th), almost 6 years after the establishment of the Reserve Bank of Australia (i.e. Australia’s current central bank). The rate of conversion was set at two [Australian] dollars per unit of Australian pound, which means that the Australian Dollar was worth US $1.12. The UK government of Wilson announcement of a 14-percent Sterling depreciation against the US Dollar (from $2.80 to $2.40, see figure 1) didn’t impact the Australian Dollar, which rate remained pegged to the US Dollar at a rate of $1.12.

II. The trends and reversals of Cable since the End of the Bretton Wood System in 1971

Note that all the periods and important events are marked in Chart 1 (see end of article).

A. The Nixon Shock and the Smithsonian Agreements (1971 – 1973)

After the Nixon Shock in August 1971, the Australian Dollar was revalued several times against the US Dollar, from its starting point at $1.12 to a historical high of $1.488 in 1974. Unlike many countries that decided to let their currency float at the end of the Smithsonian Agreements in February 1973, Australia tried to keep its exchange rate fixed (against the greenback).

B. 1974 – 1986: A Decade of Depreciation

The deterioration of the terms of trade in the mid-1970s (See Figure 2), coming from a change in economic circumstances in addition to a strong exchange rate (even versus booming economies such as Japan and Germany), led to a series of exchange rate devaluations. The first one occurred in September 1974, when the Australian Dollar was devalued by 12 percent to $1.31. The second one happened in November 1976 when the Government decided to devalue the currency by 17.5 percent, and the Aussie reached a low of $1.0160 after that announcement. The pair consolidated in the late 1970s and early 1980s to reach a high of $1.19 in January 1981, thanks to an investment boom in 1980 and 1981 following the 2nd oil shock in 1979. However, the recession that hit most the OECD countries in the early 1980s (due to the Oil Shock) reduced drastically the demand for Australia’s minerals and energy, and the inflationary pressures generated by the wage explosion of 1981-1982, both led to a perception that the Australian Dollar was starting to be overvalued. The Australian Dollar then started a two-year depreciation against the greenback, and ended its fixed regime area by a 10 percent devaluation in March 1983, when PM Bob Hawke came to power and announcement the third big depreciation in hope of spurring the export sector.

C. 12 December 1983: From a Crawling Peg to a Floating Regime

In March 1983, one unit of Australian Dollar was worth roughly 85 cents of US Dollar. The exchange rate again consolidated until the end of the year and in December 1983, the Aussie Dollar was floated and foreign exchange controls were dismantled [during the night on December 12].

In the last few years before moving to a floating regime, the Australian Dollar was pegged to the Trade Weight Index (see computation of the TWI Index in Table 1) and the value of the exchange rate was determined each day by the RBA in consultation with the government. The reason of the float move was mainly to improve the efficiency of the financial system, in addition to providing the authorities better control over domestic monetary policy (Blundell-Wignall et al., 1993).

The change in the policy resulted in a sharp appreciation of the volatility of the Australian Dollar [both bilateral exchange rate and TWI], adding pressure on the commodity currency. The exchange rate experienced significant losses against the US Dollar, reaching a low of $0.5960 in August 1986.

D. 1986 – 1989: The Aussie Strength

When it comes to Australia, the terms of trade has always been one of the fundamental drivers of the exchange rate, which is strongly correlated to commodity prices. As a result of a 50 percent increase in commodity prices between 1986 and 1989 (due to a strong increase in the world’s demand), Australia terms of trade increased from 52 in Q3 1987 to 63 in Q3 1989, hence pushing up the exchange rate USD/AUD from $0.5960 to $0.8960. During that period, Australia was experiencing an investment ‘boom’, a strong business confidence and rising national savings. Concerned about the sustainability of this economic ‘boom’ and RBA policymakers started to run a tightening monetary policy as a response to ‘deflate’ the asset price inflation wave.

E. 1990s: Weak global demand, low commodity prices and the Aussie depreciation

The US recession in the early 1990s, Japan’s beginning of the deflationary deleveraging decade in addition to the 1990s Financial Crises in Nordic Countries have decelerated global demand, impacting commodity prices and therefore shrinking Australia’s term of Trade. According to the Bloomberg Commodity Index (BCOM), commodity prices fell 42 percent between Q2 1997 and Q2 1999 (chart 2). During that same period, the Aussie depreciated by roughly 20 cents against the US Dollar, dropping from $0.80 to $0.60.

F. 1998 – 2002: The Dollar appreciation (Aussie Weakness)

As we discussed in our previous articles on FX history, the turn of the millennium was expressed by a US Dollar strength against the major currencies (we saw it with the Euro, Sterling pound and the Yen). The second part of the 1990s was characterized by the famous Clinton Dollar rally, where the USD index increased from 80 in early 1995 to 120 in early 2002 on the back of significant productivity gains, budget surpluses and capital inflows in the equity market (and especially tech stocks).

During that period, USD/AUD went down from $0.65 to hit a historical low of $0.48 in late 2001.

 G. 2002 – 2008: Global Demand and Super Cycle

The emergence of China (and other emerging market economies known as the BRICs) at the turn of the millennium led to a sharp unanticipated increase in commodity prices (see chart 2, Super Cycle), with the BCOM Index rising from the low 90s in early 2002 to almost 240 in July 2008, which resulted in a levitation of all commodity currencies. The Australian Dollar increased from its record low of $0.48 to $0.9850, more than doubling its value during those 6 years. If we look at the chart of the USD/AUD overlaid with the BCOM index (chart 2), we clearly an important correlation between the currency pair and commodity prices.

In a recent publication, Ferraro, Rogoff and Rossi (2015) showed that there exists a relationship between changes in the price of a country’s major commodity export price and changes in the nominal bilateral exchange rate for short frequency time series (daily data).

During that period, investors were also chasing the carry trade strategy, one of the most popular strategy in FX, where a typical trade would involve borrowing the currency with the lowest interest rate (such as the Japanese Yen) and investing in the currency with the highest interest rate (i.e. Australian or New Zealand Dollar).

H. July – December 2008: Risk-Off, Carry Unwinds and Aussie Crash

In the second semester of 2008, the Aussie experienced significant depreciations against the safe-heaven currencies, such as the US Dollar, the Japanese Yen and the Euro. For instance, between July and October 2008, USD/AUD went plummeted from $0.985 to 60 cents ($); more surprisingly, the Aussie depreciated almost 50 percent against the Yen, JPY/AUD went down from 104.50 to 55 during the same period.

We will talk more about the potential explanations behind the crash in our case study (Section 3), but one important thing to understand is that investors typically look at the Aussie as a risk-on asset and the currency tends to be highly correlated with equities in general. Hence, when economies plunge into recessions, equities typically fall, and so the Aussie (Chart 4).

I. 2009 – 2013: Commodity recovery and an overvalued Aussie

In reaction to the Financial Crisis, central banks lowered their interest rates down to record levels (zero bounds) and started a series of outstanding purchases of assets (QE). The recovery was immediate in commodity prices (Oil surged from 40 in 2009 to over 110 in 2011), which was one of the key drivers of the Aussie strength during that period. Note that Australia is perceived as an export driven economy: according to the World Bank, it exports totalled $190bn in 2015, with Iron Ore ($37.5bn) and Coal ($30.2bn) being the top-2 earners, with China ($62.3bn) and Japan ($$30.7bn) accounting for roughly 50 percent of the exports (see Picture 1).

Australia is also the beneficiary of a ‘double Chinese dividend’. In addition to export goods and commodities to the giant China, the shiny coasts are trending destinations for Chinese tourists. Hence, we can state that this after-crisis period was saved by Chinese demand.

On the top of that, Australia was offering a higher interest rate that developed economies; the cash rate in 2012 was 3.5%, while it was 75bps, 50bps and 0bps in Europe, UK and US respectively. It was also the only economy not to fall into a recession after the Financial Crisis in 2008, and is one of the few countries left with a triple-A rating. One interesting fact about Australia is that the last recession happened in 1991, and the country is on its way to surpass the Netherlands and its 26 consecutive year of economic growth (between 1982 and 2008).

The problem (or the curse) of all export-driven economies in periods of booms is how to deal with a strengthening currency. Thanks to its mining industry (primary industry and contributor of the country’s economy), Australia has experienced several episodes of mining boom in its history, bringing interest of foreign investors in both the country’s assets and currency, which tend to result in a currency appreciation. A mining boom resulting in a real exchange rate appreciation is what economists have called the ‘Dutch Disease’ as a persistent strong currency tends to have a negative effect on exports and various import-competing industries.

Therefore, when the Australian Dollar started to trade above parity against the greenback, there were many talks of an overvalued currency, from 20 to 30 percent above its historical mean according to some economic models.

J. May 2013 and beyond: QE Taper, End of the Super-Cycle and the Freefall of the Aussie

 On May 22 2013, the announcement of a potential “QE Taper” by Fed chairman Ben Bernanke triggered a sudden spike in volatility, with an aggressive sell-off in the emerging market. As a reminder, the Fed had been on a $85bn monthly purchase program since December 2012 at that time. Hence, the sudden comments from US policymakers created a little panic in the market that we now refer as the Taper Tantrum. Della Corte, Riddiough and Sarno (2016) worked on global imbalances and currency prermia, showing that debtor countries issue riskier currencies and offer a [currency] risk premium to compensate the risk in high periods of volatility.

Following those comments, the Aussie Dollar experience a 16 percent devaluation between May and September 2013, which was the start of a bear trend in the commodity currency. The fall in commodity prices in 2014, which analysts called ‘the end of the commodity super-cycle’, in addition to the 2014 Dollar rise and lower expected growth rates printed by China, pushed down the Aussie to a low of $0.68 in the beginning of 2016 (the same time when the front-month WTI oil contract was trading at $26 per barrel).

Since then, USD/AUD experience a consolidation, up north 10 cents mainly due to a US Dollar weakness over the past 7 months. As you can see on Chart 3, commodity prices have been steady over the past with Oil (WTI) trading at mid-40s.

III. Case study: The Aussie and the Carry Trade

The carry trade is one of the most popular strategies in the currency market, and simply consists in borrowing the currency with the lowest yield (i.e. the Yen) and invest in the currency with the highest yield (i.e. the Aussie). Chart 4 represents the JPY/AUD spot rate overlaid with the SP500 Index between 2002 and 2012. As you can see, the carry strategy during all that period was heavily correlated to equities, which tells you that you should treat carry trade currencies like a risk-on asset (i.e. equity), and that risk-on assets [all] tend to do bad in periods of rising volatility (i.e. VIX). Hence, a traditional long-equity investor who thought he was diversified by holding a carry trade portfolio experienced significant drawdowns during the financial crisis. The SP500 Index plummeted from 1,300 to 800 when the JPY/AUD exchange rate fell almost 50 percent in the summer 2008.

There is a vast amount of literature on carry trade and currency crashes; for instance, Brunnermeier, Nagel and Pedersen (2009) showed that carry trade strategies are negatively skewed, and that this skewness is due to sudden positions unwinding (carry traders are usually very leveraged). Hence, we now say that carry trade strategies ‘go up by the stairs and down by the elevator’.

In my opinion, the JPY/AUD chart is one of the (if not the) most important chart in Finance, and especially for short-term investors like myself. Every morning, I start my day with a coffee in front of the JPY/AUD, to see if something happened overnight. In Chart 5, I plotted a 5-minute history data of the JPY/AUD (black line) overlaid with the SP500 index (purple line). We can clearly see that a higher JPY/AUD is usually accompanied by a higher stock market; a sort of Pavlovian response of Cheaper Currency = Higher Equities. Hence, an positive overnight momentum on the Aussie Yen (i.e. Yen depreciation) is a good signal for the economy, and can be usually translated by ‘nothing serious happened in Asia’ (either China, Japan or Australia). However, a strong  Japanese Yen appreciation, like the one on August 28th / 29th in our chart, isn’t usually representative of a positive signal in the market, and equities tend to be red in Asia, Europe and US usually. My typical reaction would be to see what happened in Asia. This time, the Yen Strength was due to the headline of North Korea firing ballistic missile over Japan. Big {negative] overnight moves are usually link to disappointing Bank of Japan meetings, Australia lowering interest rates or a Chinese Yuan sudden devaluation.

Chart 1. USD/AUD exchange rate history (Source: Reuters)

AussieHist

Chart 2. USD/AUD spot rate (candlesticks) and the BCOM Index (line) (Source: Reuters)AussieBCOM

Chart 3. USD/AUD spot rate (black line) and the Oil prices (WTI, red line) (Source: Reuters)

AussieOil.PNG

Chart 4. JPY/AUD spot rate (candlesticks) and the SP500 Index (red line) (Source: Reuters)AussieSPX.PNG

Chart 5. JPY/AUD (5-min) spot rate (black line) and the SP500 Index (purple line) (Source: Reuters)AUDJPY.PNG

Figure 1. USD/GBP exchange rate since 1971 (Source: Bank of England)

GBP.PNG

Figure 2. Australia Terms of Trade History and Real TWI (Source: Gillitzer and Kearns, 2005)

Picture 1. Aussie Exports for 2015 (Source: OEC)

 

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

Introducing the 3D challenge – Debt, Demographics and Disruption (with a US case study)

Abstract: As a response to the Financial Crisis of 2008, central banks have been running persistent loose monetary policies (NIRP and aggressive asset purchase programs) in order to generate some growth and inflation. Even though the measures chosen by policymakers mainly came from the burst in the housing market (US and Europe), developed economies have also been cornered with another long-term big issue: the 3D problem – Debt, Demographics and Disruption. Demographics reveal a dramatic aging of the developed world’s population (‘Baby Boom effect’), which has been playing a role in the desire of consumers to save more than actually spend. In addition, the long-term solvency of public and private plans has also been a growing concerns across the developed nations, adding pressure on current workers to increase their amount of savings based on a shift in expectations of higher taxes to sustain the secular change in demographics. The effect of an increase in savings have been one of the main factors of a decrease in inflation expectations across the world in addition to a sluggish growth, forcing policymakers to maintain a loose monetary policy, cutting rates to even negative territory and diversifying the asset purchase programs (corporate bonds, ETF and Real estate). The slowdown of inflation, and even deflation for some countries, is an issue for developed nations as it increases the country’s debt in real terms, putting the country under pressure and questioning its long run sustainability.

We then look at the US economy for our case study on the 3D problem. Our analysis is composed of three sections: in the first one we quickly review US demographics challenge, then in the second section we present the US Federal and Household debt, and in the third part we introduce Disruption in different sectors of the US economy.

Link ==> 3D Problem

Behavioural Equilibrium Exchange Rate (BEER) model

Abstract: In this article, we introduce another method for evaluating the ‘fair’ value of a currency: the Behavioural Equilibrium Exchange Rate (BEER), a model which is widely used in practice. The BEER model was developed by Clark and MacDonald (1999) and estimates the fair value of currencies according to short, medium and long-run determinants. An important concept is that there is no prior theory for the choice of economic variables; hence, the choice of variables is based on economic intuition and data simplicity and availability.

We also do an application of the BEER and run a Fixed-Effect panel regression on the G10 currencies, using the US Dollar as the base currency, and three widely used macroeconomic variables – inflation, terms-of-trade and interest rates – for our regression. We conclude by commenting the results and making a brief analysis on the Euro (Spot rate versus BEER value).

 LINK ===> BEER_Models

Excel Data ===> Data BEER_New

Rising US corporate default rates during a tightening monetary policy cycle

In this study, we mainly focus on the refinancing issues that US [non-financial] companies will face within the next five years as a lot of corporations are trading at a distressed price (or yield) due to the lack of global growth and low commodity prices. In the first session, we review the US credit market structure. Then, the second session introduces a two-state Markov switching model (Hamilton, 1989), followed by a presentation of the paper Corporate bond default risk: a 150-year perspective (Giesecke & al., 2011), a study that uses a set of macroeconomic and financial variables to forecast default rates in the US. In the third Section, we comment the potential change in the explanatory variables since 2009 and we discuss a solution to avoid a new clustered default event over the next five years.

Link ==> Studies on Corporate Defaults