Japan, the Yen and the Aussie

Three days ago, we saw that Japanese GDP contraction in the second quarter was revised to an annualized 7.1% QoQ (vs. 6.8% previously), shrinking at its fastest pace in more than five years, due to a deeper decline in consumer spending and a bigger fall in capital expenditure (money used to purchase, upgrade, improve or extend the life of LT assets). In addition, the Ministry of Finance reported that the country showed market a current account surplus of 416.7bn Yen in July (slightly less that 444bn expected and 30% down compare to July last year) as the income from foreign investments (up 2.8% to 1.853tr Yen) outweighed the trade deficit (964bn deficit Yen in July, August one to be released on Sep 17th).

While the unemployment has fallen quite sharply since Abe’s election (4.5% in Dec 2012) to 3.8% in August, real wages have constantly been declining over the past few years (they fell by 3.8% YoY in May, the sharpest decline in years). One explanation of the fall in real wages we read lately (The Economist, Feeling the pinch) was that Japan’s labour market is divided between two sorts of employees, regular ones who are usually highly paid and protected [against being fired] and the non-regular [low-paid] ones. If you have a look at the figures, non-regular workers accounted for 36.8% of all jobs in June, a high number compare to historical standards and therefore confirming that most jobs created since Abe took office were non-regular workers.

This definitely explains weakening figures in household spending. We saw that July Household Spending fell 5.9% YoY, twice what economists expected, printing in the negative territory for the fourth time in a row. As a reminder, Japan is a consumer-driven economy (61% as a percentage of GDP in 2012 according to the World Bank); therefore the BoJ will watch closely those figures in order to avoid another dismal quarter.

However, according to the Bank of Japan Deputy Governor Kikuo Iwata, the economy is ‘gradually recovering’ and it is all about the sales tax increase effect. Moreover, with the BoJ now monetizing debt at negative rates (T-Bill 12/08/2014 has been trading in the negative territory for the past few days as you can see it in the chart below), Iwata added that he didn’t see ‘any difficulties in money market operations’.

sg2014091052862(1)

(Source: Bloomberg)

Quick review on USD/JPY

The recent surge in the stock market (Nikkei up 1,000 pts over the past month, closing at 15,788.78 earlier this morning) mainly coming from ‘more QE coming soon’ speculation combined with demand for international securities (Bonds, Stock) from Japanese funds have both played in favour of the depreciation of the Yen lately since it broke out of its 101 – 103 range on August 20. In addition, with US yields starting to ‘surge’ (10-year yield up 20bps over the past two weeks and now trading at 2.53%), USDJPY was sent up to 106.85 during today’s trading session, breaking its resistance of 105.44 (Jan 2nd high) and trading to levels seen back in September 2008. If the depreciation continues, the next MT target on the pair stands at 110.

Aussie updates…

AUDJPY (black bar) eased a bit from last week’s [16-month] high of 98.65, down more than a 100 pips (carry trade unwinds combined with AUD selling from corporate and macro names), taking the equity market (red line) with ‘him’ (S&P closed below the 2,000 level at 1,988).

AUDJPY-10-Sep(1)

(Source: Reuters)

The AU benchmark (S&P/ASX) index came back to a 3-1/2 week low after Westpac’s index of consumer sentiment reported a 4.6% decline in September, bringing the Aussie below the 0.9200 support against the greenback.

AUDUSD is also trading below its 200-day MA (0.9180) for the first time in five months. Market has turned bearish on the pair as the failure to hold the 0.9180 – 0.9200 support area has opened up further retracements levels: 0.9075 (61.8% Fibo retracement of 0.8658 – 0.9756), followed by 0.9030. Australia will report employment figures overnight (2.30 am), which traders expect to be disappointing, therefore sending the Aussie to lower levels.

AUD-10-Sep(1)

(Source: Reuters)

Could we survive without QE?

As we are approaching the end of QE (the Fed will probably announce a $10bn / $10bn and then 5bn cut in the next three meetings), we thought it is a good time to have a quick recap of the US QE history since the Great Financial Crisis and its impact on the equity market.

QE1 (December 2008 – March 2010): On November 2008, roughly two-and-a-half months after the Lehman Brothers collapse, the FOMC announced that it will purchase up to $600bn in agency MBS and agency debt and on March 18, 2009, Bernanke and its doves announced that the program would be expanded by a further $750bn in purchases of MBS and agency debt and $300bn in T-bonds. At that time, the Fed had approximately $750bn of Treasuries ad MBS on its balance sheet.

QE2 (November 2010 – June 2011): After 9 months of stagnation in the stock market, the FOMC decided to go for another round of quantitative easing on November 2010 and announced that it will purchase $600 bn of LT Treasuries, at a pace of $75bn per month. Stock market started to rallied once again (S&P was up approximately 10%) as by applying this un-conventional monetary policy, the Fed brought interest down to the floor and ‘forced’ investors to move to the stock market in order to receive a more interesting real rate.

Operation Twist (September 2011 – December 2012): While the stock market was plummeting (S&P was down 300 pts to hit 1,075 a few months after the end of QE2), it didn’t too long for the Fed to react and on September 21st 2011, the FOMC announced Operation Twist. In this program, the Committee intended to purchase, by the end of June 2012, $400bn of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. The main goal was to lower long-term rates in order to stimulate consumer spending and corporate borrowing as growth was judged sluggish by US policymakers at that time. In the middle of 2012, the FOMC downgraded its growth expectations from 3.5% (a year earlier) to 1.9% – 2.4%.

By the end of June 2012, the Fed extended the monetary twist program and said it would purchase another $267bn LT Treasuries by the end of the year, bringing the program up to $667bn.

QE3 (September 2012 – December 2012): With inflation in the US plummeting from 3.9% in September 2011 to 1.4% in July 2012 and credit continuing to contract and still disappointing unemployment figures, the FOMC decided at the September 2012’s meeting (13th) to initiate additional open-ended purchases of residential MBS for an outstanding amount of $40bn every month. Combined with the (approx.) S45bn monthly purchase of US LT Treasuries, the FOMC will increase the central banks’ holdings of LT securities by about $85bn each month, which should ‘put downward pressure on the LT interest rates, support mortgage markets and help to make broader financial conditions more accommodative’ according to the Fed’s statement.

QE4 (December 2012 – December 2013): With Operation Twist coming to an end and US policymakers still judging the recovery as ‘fragile’, the Fed decided to continue to purchase $45bn worth of US LT Treasuries, raising the amount of QE to $85bn on a monthly basis. Its goal at that time was to drive economic activity so that unemployment rate drops to 6.5% (it was standing at 7.7% at that time), as long as inflation remains below 2.5%.

And it went on, that year the Fed increased its balance sheet by a trillion+ dollars, bringing it to a record high of $4trn in December 2013 and which could totally explain the 30% increase in the stock market and the 10% appreciation in the housing sector (Reminder: for the 2013 fiscal year ended Sep. 30th 2013, the US Congressional Budget Office – CBO – announced that the deficit fell drastically to $680bn from $1.087tr in 2012).

QE Taper (December 2013 – ): As the unemployment rate was falling faster than expected in 2013 (down 1% to 6.7% in December 2013), the Fed officials decided to start its QE Taper, announcing that it would scale back its monthly purchases by S10bn each meeting (Auto-pilot strategy). After almost two years of extended QE and with the Fed’s balance sheet up 1.5tr USD (according to FARBAST index), we are now three meetings ahead of the QE exit (last cut expected to be on December’s meeting). The real question now is: would the ZIRP policy on its own be enough to support the equity market (and the housing sector)?

We saw some turbulence back in January this year when the market corrected 5.5 – 6 percent (between mid-Jan and February 3rd) and also in end-July/August where we saw another 4.5-percent correction in the middle of high geopolitical tensions (11.7% of the World is at war according to a DB analysis, see chart at the end). However, it seems that the market has perceived those ‘corrections’ as new buying opportunities and the S&P 500 has been flirting with the 2,000 level for the past week (closed four days out of five above 2,000 over the past week). The index is already up 8.3% since December 31st 2013 close (1,848.36) and we are asking ourself, how far could this go? Especially now that the Fed is now giving us some updates concerning its ST monetary policy, and is potentially considering raising rates (currently at 0 – 0.25%) sometime next year (Q3 seems to be the market’s view). We are going to steal Stanley Drunckenmiller’s sentence: ‘Where does the Fed’s confidence come from?’

Aren’t policymakers supposed to wait a little bit after Taper ends in order to start focusing on its ST interest rate policy?

Even though the rate hike is priced for Q3 next year based on the market’s expectations, we don’t see the point of starting talking about an ‘eventual rate hike’, and especially after the only excuse you had to explain a 2.9% contraction in the first quarter (because there has to be always an explanation) is to blame the weather. In our opinion, US policymakers’ plan sounds a bit ambitious.

Chart: S&P 500 index and QE history

S&PQE(1)

(Source: Reuters)

Another popular chart that we like to look at is the equity market (S&P500 index) overlaid with the Fed’s balance sheet (FARBAST index). As you can see it, it is clear that the Fed’s balance sheet expansion have played in favour of the equity market. Liquidity drives asset price higher and we believe that we are about to hit the high of the asset price inflation we have seen for the past six years…

FEDSP(1)

(Source: Bloomberg)

Appendix

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