The $64,000 question

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.

Source: Fed, US Treasury, RR estimates

Great chart: TOPIX vs. USDJPY

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.

Source: EIkon Reuters

SP500: average strategists’ forecast for 2021 reaches new high

As we previously saw, the massive liquidity injection from major central banks to prevent the economies from falling into a global deflationary depression has generated a significant rebound in equities prices, especially for the mega-cap growth stocks. Figure 1 shows that the FANG+ index is trading over 50% higher than its February high, which was mainly driven by the surge in global liquidity.

Figure 1

Source: Eikon Reuters, RR calculations

In addition, the major 5 central banks (Fed, ECB, BoJ, PBoC and BoE) are expected to increase their balance sheet by another 5 trillion USD in the coming 2 years, to a total of 33 trillion USD, to cover the high costs of national lockdowns.  As a result, ‘Wall Street’ strategists have constantly reviewed their SP500 forecasts for 2021 to the upside in recent months, with the average forecast rising to 4,035 in December according to Bloomberg.

With central banks ‘ready to act’ as soon as we see a sudden tightening in financial conditions (due to a drop in equities), the risk reward in the SP500 is currently skewed to the upside with all the liquidity injections expected to reach markets in the coming months.

Figure 2

Source: Eikon Reuters, Bloomberg

Growth stocks loves liquidity

Even though a significant amount of investors have become increasingly worried about the current state of the equity market and how ‘extremely stretched’ the equity positioning has been in recent weeks, they must not underestimate the force of the liquidity injections coming from central banks. Figure 1 shows the evolution of the major 5 central banks’ assets since 2002 (Fed, ECB, BoJ, PBoC and BoE); after rising by over 7 trillion USD since March, assets of the top 5 central banks are expected to grow by another USD 5tr in the coming two years up to USD 33tr in order to support the high costs of running restrictive economies to fight the pandemic.  

Figure 1

Source: Eikon Reuters, RR calculations

Therefore, although some fundamental ratios such as price-to-sales or the traditional P/E ratio have reached stratospheric levels for some companies and also for the entire equity indexes (for instance, Robert Shiller’s CAPE ratio was of 33.1 in November, far above its 140-year average of 17.1), the constant liquidity injections could continue to support the equity market in the near to medium term, especially the FANG+ stocks. Figure 2 shows the strong co-movement between the total assets from the major 5 central banks and the FANG+ index; we can notice that the titanic rise in central banks assets has ‘perfectly’ matched the strong rebound in the mega-cap growth stocks in the past 8 months.

With 5 trillion USD of assets expected to be added in the coming 24 months, is it really time to be bearish on tech stocks?
Figure 2

Source: Eikon Reuters, RR calculations

Great Chart: Oil Prices vs. Japan Trade Balance

The recovery in oil prices since February 2016 has eased financial conditions for most of the Middle East countries and has reversed the path of the corporate default rate for US energy companies exposed to the shale industry. Higher oil prices have also brought back inflation in most of the economies, hence pushed up expectations of nominal growth rates. However, for countries that are heavy importers of energy (i.e. Japan), higher oil prices usually mean a deterioration of the Trade Balance. Japan has limited domestic proved oil reserves (44 million barrels), which means that the country is a net importer of oil. According to the EIA, Japan is the fourth-largest petroleum consumer and the third largest net importer, and its daily consumption in 2016 was of 4 million barrels per day. Therefore, if we plot the WTI futures prices (6M lead) with the Japanese trade balance, we can notice a significant co-movement between the two times series. This chart suggests that oil prices can be used as a sort of leading indicator for the Japanese trade balance. For instance, when oil prices entered a bear market in 2014, the trade balance switched from a 1.1tr JPY deficit in the middle of 2014 to a 350bn JPY surplus in H2 2016. Hence, with oil prices constantly trending higher with the front-month contract on the WTI trading at $70 per barrel, its highest level since Q4 2014, we can potentially anticipate that the Japanese trade balance will go back into deficit in the medium term.

What are the consequence for the Japanese Yen?

In our BEER FX model, we saw that exchange rates (in log terms) react positively to a positive change in interest rate differential and in terms of trade differential, and negatively to a change in inflation rate differential. Hence, if we expect import prices to rise in Japan due to higher energy costs (especially Oil), the terms of trade should ‘deteriorate’ and therefore have a negative impact on the currency. However, we know that the Japanese Yen is also very sensitive to the current macro environment and often acts as a safe-have asset when the risk-off sentiment rises (Yen appreciates in periods of equity sell-off). In our view, the problem Japanese officials may face in the following 6 months is higher energy prices combined with a strong Yen at 105 (vis-à-vis the US Dollar), which will directly weigh on the country’s economic outlook as fundamentals will start to deteriorate, leaving less and less room for some BoJ manoeuvre.

Chart: Oil prices (WTI, 6M Lead) vs. Japan Trade Balance (Source: Eikon Reuters)

Japan Trade

Great Chart: Term Spread Differentials (US, Germany and Japan)

In this article, we define the term spread of a specific country by the difference between the long-term (10Y) and the short-term (2Y) sovereign yield, which is also referred as the yield curve. As we mentioned it in one of our previous Great Chart articles (here), empirical research has shown a significant relationship between the real economic activity of a country and the yield curve. In today’s edition, we chose to look at the historical developments of the term spread differentials, between the US and Germany and the US and Japan.

Over time, we notice that the term spread has some interesting co-movement with the exchange rate. For instance, between 2005 and 2017, a widening term spread differential between the US and Germany was favourable to the USD/EUR exchange rate (here), meaning that the Euro was appreciating when the US yield curve was steepening more significantly than the German one. However, we saw that the relationship between the two times series broke down in early 2017 and has actually reversed over the past 14 months (here). In other words, based on the current market levels, the 2Y10Y term premium in Germany offers 56bps more than the US. Hence, as the term structure in the US has flattened strongly relative to Germany (yield curve steepened from 50bps in July 2016 to 118bps), the US Dollar depreciated.

This chart shows the evolution of the term spread differentials – between US and Germany and between US and Japan – since 1985. We can observe a strong correlation between the two times series over the past 30 years, with the term spread differential against Germany trading at -57bps, its lowest level since June 2006, and at 42bps against Japan, its lowest level since June 2008, respectively. An interesting observation comes out when we look at the spread between the two TS differentials (US-Japan vs. US-DE), which simply comes back at looking at the cross term spread differential between Germany and Japan. At the exception of the year 1992, the DE-Japan TS differential has always traded between -1% and +1%, and is currently standing at the high of its long-term range. The TS differential currently trades at +1% on the back of a steepening German yield curve since the summer of 2016 (2Y10Y moved from 52bps in July 2016 to 119bps today). It it a good time to play the convergence between the two term structure, i.e going long the German 2Y10Y term spread and short Japan 2Y10Y? The risk of the trade is on Japan side, as shorting the 2Y10Y would imply a steepening yield curve with either the 2Y yield going down or the 10Y rising. With the current BoJ ‘yield curve control’ (YCC) policy, we know that a steepening yield curve in Japan is difficult for the time being, but it will be interesting to see where TS differentials stand in a couple of months.

Chart: Term spread Differentials – Japan and Germany vs. US (Source: Reuters Eikon)

Term Spreads ALl

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) 

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

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.

Dollar pause: poor US fundamentals or overall disappointment on more global easing?

Since its high in mid-March last year, the US dollar has ‘stabilized’ vs. overall currencies; if we look at the US Dollar index (Source: Bloomberg, DXY index), it hit a high of 100.40 in March 13th then has been ranging between 92.50 and 100 over the past year. Now the question we have been asking ourselves is‘what is the main reason for this stagnation?’

USDIndex

(Source: Bloomberg) 

We strongly believe that one of the main reasons comes from looser-than-expected FOMC statements and a shift in expectations on more monetary policy tightening in the near future. If we look at the market, Fed Funds futures predict a much lower ST rates in the future compare to the Fed’s dot plot. Looking at the chart below, whereas the Fed officials see rates at around 1% and 2% by the end of 2016 and 2017 respectively, the market (Red line) predicts 50bps and 1%. It doesn’t necessarily mean that the market participants are right, but it looks to me that they are more ‘rational’ based on current market conditions and this spread between the Fed and the market may have created a dollar pause over the past year.

FedPlotvsMarket

(Source: Bloomberg)

The first reason that could explain why the Fed has been holding rates steady since last December would be the poor fundamentals we have seen lately (except for the unemployment rate currently at 4.9%). For instance, US GDP growth rate has been slowing over the past three quarters and came in at 1.4% for the last quarter of 2015 (vs. almost 4% in Q2). If we look at the latest core PCE deflator release (the inflation figure the Fed tracks), the index came in at 1.56% YoY in March, still far below the Fed’s ‘target’ of 2%. In addition, the economic data have been more than disappointing overall, which could explain the recent fly-to-quality and why yields are starting to plunge again (the 10Y YS yield trades currently at 1.8%, while the 30Y is at 2.66%).

Secondly, corporate profits have been plunging and printed a 7.8% fall in Q4 2015, the biggest decline since Q1 2011 (-9.2%) and the fourth decline in the last five quarters. If we look at chart below, we can see that the divergence between the S&P500 index and the 12-month forward earnings doesn’t work for too long and equities tend to be the one moving in general. You can see that in that case, equities are still overvalued based on this analysis and there is more potential downside coming in the future.

SPXFEPS

(Source: ZeroHedge)

The third and most important reason explaining this status quo – i.e. US dollar pause – would be the current global macro situation. Certainly, market participants have been recently disappointed by the recent news coming either from Japan (no additional QE see article) or the Eurozone and the loss of confidence in the ECB. On March 10th, Draghi announced the ECB Bazooka plan, where the officials decided to:

  • cut decrease the deposit refi and marginal lending rates to -0.4%, 0% and 0.25% respectively
  • Increase the QE from 60bn to 80bn Euros per month
  • Implement a four new target LTROs (TLTROs) each with maturity 4years
  • Include investment grade euro-denominated bonds issued by non-bank corporations clong the assets that are eligible for regular purchases

The effect on the market was minor; if we look at the chart below, the Euro increased in value against the greenback (green line) and the equity market stands at the same level since the announcement (Eurostoxx 50 index trading slightly below 3,000).

EUROstoxx

(Source: Bloomberg)

The sales-side research suggest that CBs should consider purchasing equities as well or taxing wealth (Deutsche Bank) as a intermediate step before implementing the Helicopter money strategy.

Despite a recent spike since the beginning of the year mainly driven by the recovery in oil prices (WTI spot increased from 26$ to 43$ per barrel), commodity prices are still trading at their lowest level since 1998 according to the Bloomberg BCOM index (see chart below). China’s (and other EM countries’) slowdown continue to weight on international finance putting a lot of export-driven countries into difficulty (or close to default). We personally believe that this situation will remain in the next 12 to 18 months as the emergence of a credit crisis in the EM market is not too far away.

CommodityPrices

(Source: Bloomberg)

Therefore, we think the global lack of easing will tend to stabilized the US dollar in the medium term; another rate hike from Yellen in one of the next two meetings is sort of priced in by the market, therefore only action from the rest of the world could start to bring interest into the US dollar. we would be careful of going short equities at the moment as USDJPY is very low and a response from the BoJ (more ETFs purchases) is kind of imminent if Kuroda wants to stop this current equity sell off and Yen purchases.