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.

Japan: A Loss of faith in Abenomics

As we were currently writing an update on Japan current situation, with a brief introduction to helicopter money [a name that has been running around the street for the couple of weeks now], we would like to share the piece we wrote last month which will give you an overview of the country’s current situation.

Japan: A Loss of faith in Abenomics  (June 13th, 2016)

I. Quick Japanese recap story

A. Japan and the two lost decades

Since the private sector debt bubble burst in the early 1990s, Japan had been stuck in an ‘ugly deflationary deleveraging’ (also called the ‘Lost Two Decades’). For the past two decades, real growth has averaged 1.1% with a persistent deflation of -0.5%. This situation has led to an exponential expansion of the government debt which crossed the one quadrillion yen mark in August 2013 and a debt-to-GDP ratio of 230% (according to Bloomberg index GDDBJAPN Index), the highest in the developed world. To give you an idea, Japan’s debt is larger than the economies of Germany, UK and France combined.

Moreover, if you add in private and corporate debt, total Japanese debt stands at 500% as a share of GDP (vs. 350% in the US).

B. What is Abenomics?

With 10 different FinMin and 7 PrimeMin since 2006, the Japanese economy was desperately in need of a grand strategy. Therefore, the re-elected PM Shinzo Abe announced in December 2012 a suite of measures called Abenomics. His goal was to revive the Japanese economy with the so-called ‘three arrows’:

  1. Massive fiscal stimulus : the government announced in January 2013 that it will spend 10.3tr Yen in order to generate some growth, create about 600,000 jobs and increase the inflation rate.
  2. Quantitative easing : On April 4, the BoJ introduced its QQME ‘quantitative, qualitative monetary easing’ program in order to reach a 2-percent inflation, a program where the central bank will double the size of its monetary base from 138 to 270 trillion years over the next two fiscal years (fiscal year runs from April 1 to March 31 in Japan).
  3. Structural reforms : This is more a LT projects where PM Abe wants to increase Japan’s real economic growth rate to 3% by 2020 (compare to the 1%+ of the last two decades). The LDP party has several targets such as to foster trade, provide excellent education, raise women’s labour participation rate, improve infrastructure exports, reconstruct the Tohoku region. This arrow is more subjective and is not still understood by most of the people.

C. Consequences on the Japanese economy

Most of the effect of this massive stimulus program was reflected in the currency, with USDJPY soaring from the mid 70 range to 125.85 (Green line) in June last year, sending stock (Nikkei 225 – candlesticks) from 8,500 to 21,000, therefore raising hope of a Japanese recovery.

JapNikkei

(Source: Bloomberg)

The massive stimulus program generated some growth and inflation for the first year; as you can see it on the chart below, the inflation rate (Nationwide CPI YoY) hit a high of 3.7% in May 2014 and the economy grew by 1.4% in 2013.

(Source: Trading Economics)

However, this fairy-Abe story came to an end very quickly and was first reflected in the economy and the inflation, then in the Yen strength and equity since June last year. It is hard to believe that after all Abe/Kuroda efforts (i.e. expanding the BoJ balance sheet), we are now back in the same situation with an annual inflation rate at -0.3% and an economy close to entering into its fifth recession since the Great Financial Crisis.

II. What are the issues in Japan?

A. The vicious debt spiral

When it comes to Japan, the first thing to analyse is the country’s debt and fiscal situations. As we can see it on the chart below, Japan has constantly be running large amount of fiscal deficits (7-8% as a share of GDP) since GFC and obviously led to a ballooning debt-to-GDP ratio, which grew from 162% in 2007 to 230% in 2015. In their book This time is different, economists Carmen Reinhart and Kenneth Rogoff claimed that rising levels of government debt are associated with much weaker rates of economic growth, indeed negative ones. If debt reaches 90% of GDP or more, the risks of a large negative impact on long term growth become largely significant.

(Source: Trading Economics)

The fact that Japan has never experienced market ‘attacks’ is because most of its debt (95%) is owned internally by major institutional investors (GPIF, Japan Post Bank and more recently the Bank of Japan). However, with now more than one quadrillion yen of public debt, Japan spends 17.6% of its tax and stamp revenues in interest payments (9.9tr Yen of the 57.6tr Yen revenues) as the ministry of finance reported it in their last highlights of the Budget for FY 2016 (see picture 1).

Studies (Moody’s) have shown that countries’ sustainability start to decline sharply if governments use more than 10% of their revenues from tax (and stamp) to cover the interest payments. In addition, the low-yield environment imposed by easy monetary policy run by the BoJ (negative interest rate and QQME purchases at a record high of 80tr Yen of Japanese Government Bonds) have allowed Japan to borrow at a negligible rate: the 5-year yield currently trades at -23bps, the 10-year at -11bps and the 30-year yield is at 33bps (June 1st 2016). In other words, it is free for the Japanese government to borrow in the market.

However, if yields start to rise in the future based on a lack of confidence from Japanese investors and institutions, and consequently Japan starts rolling their bonds with nominal rates of 2 or 3% on the 10Y / 30Y, the default rate will start to rise dramatically. In economics, this is known as the Keynesian debt-end point, when a country starts to spend a major cut of its revenues in debt interest payments.

Picture 1. Japan’s Expenditures and Revenues – FY 2016

JapanFiscal

(Source: FinMin)

Lower taxes, lower revenues: what is the model?

In order to restore a fiscal stability, the government decided to raise its VAT tax from 5%to 8% in April 2014 for the first time in years, with a plan to raise it again in October 2015 (ambitious plan). The result were catastrophic on the economy and Japan entered straight into a recession two quarters after the hike. As a result, officials decided to postpone the second raise (from 8 to 10%) to January 2017.

In recent news, PM Abe mentioned at the G-7 summit in Shima (i.e. hinted) that the second VAT rate hike was potentially going to postponed, perhaps as much as three years, in order to avoid another recession.

More importantly, Abe also pledged several times to follow through with a corporate-tax cut in order to ramp up domestic investment. The current tax rate stands at 32.11%, and the government plans to lower the effective tax rate below 30 percent ‘next year’ (precisely at 29.74%). This view will potentially ‘force’ the companies to use their cash piles for investment on plants and equipment.

It is true that the Japanese rate on corporations is one of the highest in the industrialized countries, however the question is: Can Japan afford to lower its corporate tax rate?  With PM Abe postponing the VAT rate hike as well, the consequence is that we could see higher debt interest payments as a share of revenues, rising the fear of a potentially technical default.

B. Demographics, the shrinking country…

In a recent study, the IMF showed that the population could drop below 100 million by 2048 from 127 million today, and as low as 61 million by 2085. As you can see it in the chart below, Japan population peaked at 128 million and is expected to shrink to 124 million by 2020.

(Source: ZeroHedge)

The country’s fertility rate declined from 4.0 post World War II to 1.38 today, below replacement level, making it difficult for the government to come up with primary surpluses in the next decade. The number of Japanese aged 65 or older has reached a new record of 26.7 percent (of the population); in addition, a third of the population is above 60. This situation has broad and severe implications as fewer workers and less labour will reduce the potential output of the country, making it difficult for Abe to reach a total 20% growth in the next five years. As a reminder, PM Abe announced in September 25th last year that his intention was to raise Japan’s GDP by 100tr Yen by 2021 (i.e. from 500tr to 600tr Yen).

The rising number of retirees will increase the government spending over the years, downgrading the sustainability of the country. Moreover, with less people entering the workforce than the ones leaving (see picture 2), and with the sovereign yield curve negative up to 15Y (i.e. killing pension funds and mutual funds revenues), pensions reforms will be implemented in the medium term, shrinking the consumption rate and therefore also impacting the country’s GDP. The $1.3-trillion GPIF fund (Government Pension Investment Fund), the world’s largest pension funds, saw a 6tr Yen ($54 bn) decline for the fiscal year ending in March, its biggest losses since the Great Financial crisis. Negative interest rate policy run by the BoJ in addition to the massive monetary stimulus program have pushed Japanese institutional investors to increase their exposure to equities. The problem as we saw is that these pension funds (such as the GPIF or Japan Post Bank) are now very sensitive to the recent moves we saw in equity. Since the Nikkei 225 index peaked in the end of June last year (20,952), the Japanese equities are now trading below 17,000, down 20% in almost a year. With these pension funds being very (or over) exposed to equities, it seems that Abe cannot lose his battle versus the Nikkei Index.

Picture 2. Japan demographics change (The Economist)

JapDemogr

C. Poor fundamentals (real wages conundrum, savings, manufacturing PMI)

  • Real wages conundrum: Despite a low unemployment rate at 3.2% (vs. 4.5% back in 2012), real wages (base wages adjusted from inflation) in Japan are sluggish and have been falling constantly since 2010 (see chart below), undermining the purchasing power of households. The optimistic plan to push companies to raise their wages has been constantly delayed or slowed down by the private sector, therefore making it difficult for the economy to sustain inflation, consumption and growth. Even though a lot of people see Japan as an exporter, the main contributor of the country’s GDP comes from consumption (60.7% as a share of GDP).

JapanRealW

  • Savings: After all these years of unlimited money printing (and negative interest rates), we now start to understand that the central bank’s goal is to force also individuals to put their savings into equities as holding cash in the bank doesn’t earn any interest. Despite Japanese banks not passing on the negative carry to their clients, we would have thought that the non-interest bearing account would drive savings down. However, Bank of America ML proved that NIRP policy doesn’t necessarily push savings rate down; with almost €2.6 trillion in negative-yielding debt in Europe, they discovered that savings were going up and not down. Economics studies have told us that negative rates should force people into higher yielding funds or vehicles (stocks for instance) with agents anticipating inflation in the near futures. In reality, BofA claim that ‘ultra-low rates may perversely be driving a greater propensity for consumers to save as retirement income becomes more uncertain’, therefore implying that in period of great uncertainty, nervous people don’t tend to spend but are more keen on saving.

BoARealWage

(Source: BoA)

Japan used to have one of the world’s highest savings rates, but it has constantly been falling from a high of 23.1% (of disposable income) in 1975 and has been oscillating around 0 percent since the turn of the century. However, most of this decline is due to the shrinking number of people in the workforce, however the new generation of workers (willing to take more risk) may be willing in building savings in case of a sluggish growth and the threat of a potential bond crisis.

  • Manufacturing sector is declining: we saw recently that the Nikkei Japan Manufacturing PMI plunged to a 40-month low in April at 47.7 (below its expansion level at 50), its weakest level since the start of Abenomics (See chart below). Economic weakness overseas (mainly coming from China’s slowdown) crashed exports and capital spending; in consequence, the end of the commodity super-cycle decreased demand for mining equipment. Moreover, according to Goldman Sachs research, companies in the western world have been using most of their earnings into dividends and stock buybacks instead of capital expenditure and research and development. Historically, it has been an important driver of long-term growth as capital investment make workers and companies more productive. Japanese companies today have the oldest equipment of the western economies due to the lost decades after the bubble burst in 1989.

(Source: Japan FinMin)

D. International Trade are collapsing

We saw recently in a report from Bloomberg that global trade with Japan has been collapsing over the past three years. As you can see it on the chart below, exports are down 10.1% YoY and imports plummeted by 23.3% YoY (posting their 16th straight YoY drop). Therefore, the result is Japan have been showing trade surplus over the past couple of years (+7.5bn USD in April); looking at the trade balance ‘only’ isn’t enough to determine if the international trade activity is doing. We have the same situation that peripheral countries of the Euro Zone have experienced after the Great Financial Crisis, a recovering trade balance due to a collapse in imports.

In addition, with a Yen 14% stronger versus the US Dollar since June high, it is not going to help exports grow in the next few quarters, and may potentially increase the risk of another recession coming ahead.

ExportsJapan.png

(Source: Bloomberg)

III. Consequence of such measures

A. The BoJ’s hidden shadow

Based on the several issues we mentioned before, it is clear that Japan needed a weaker currency to reboost its economy after more than twenty years of sluggish growth and almost no inflation. Moreover, the fact that the country is located in an area where most of the countries have had an undervalued currency and cheap labour costs has had a major impact on Japanese international trade. However, the problem with running a sort of unlimited money printing strategy has a major dark side. Japan was the first developed economy to cut rates below 1% in January 1996 (chart below) and the first country to try QE in order to stimulate the economy and generate some growth and inflation. According to the BoJ, the total notes and coins in issue have reached 100 trillion Yen, with a 6tr Yen YoY increase in the last year. It is the highest rate in physical notes and coins since 2002, a year when fifty two banks went bankrupt in Japan.

QEJapan

(Source: Horseman Capital Management)

At the end of May 31 2016, the Bank of Japan’s balance sheet totalled 425.7 trillion Yen in assets (red line); government securities accounted for 370.5 trillion Yen. For an economy of roughly 500 trillion Yen, the central balance sheet total-asset-to-GDP ratio stands at 85%, an outstanding number compare to the major economies where the ratio stands between 20 and 30 percent.

In addition, by purchasing 80 trillion of JGBs every year, the BoJ is now the major holder the country’s government bonds with 35%. This ratio is expect to reach 50% by the end of 2017.

 

(Source: Japan Macro Advisors)

The central bank is also purchasing 3.3tr Yen if ETFs and now owns 55% of the country’s ETF according to Bloomberg (see chart below). As the plan doesn’t seem big enough to stimulate Nikkei stocks, market participants speculate that the BoJ will eventually more than double the plan to 7 to 8 trillion Yen. As Bloomberg reported in April, the BoJ is now a ranked as a top 10 holder in more than 200 companies of the Nikkei 225. If the central bank increases its ETF purchases to 7 trillion Yen, Goldman Sachs reported that the BoJ could become the number 1 shareholders in 40 companies, and potentially the top owner in 90 companies with a 13-trillion program.

By purchasing and holding the Exchange-traded stock, the BoJ becomes the holder of the underlying stock; the central bank’s holdings amount to about 1.6% of the total capitalization of all the companies listed in Japan.

ETFJap

JapanHolders

(Source: Bloomberg)

This situation cannot last for too long, otherwise the companies’ valuation will start to be completely detached from the fundamentals. And what happens when the Bank of Japan starts exiting, will those valuations fall? It seems that in Japan, today, only BoJ matters…

B. Distorting the market

First of all, the consequence of running this long period of zero (now negative) interest rate policy in addition to all these QE rounds for the past 20 years have completely crashed the Japanese yield curve. Government bond yields are now negative up to 15Y, the 30Y yield trades at 31bps and the 6-month T-Bills reached a low of -0.31%. This low yield curve is destructive not only for pensions and mutual funds, but also for the bank earnings. It was reported by Moody’s that Japanese regional banks generated a mere 0.28% return on assets in FY2015. In their paper The influence of monetary policy on bank profitability, Borio & al. found that low interest rates and flat term structure tend to erode bank profitability.

MarketBonds

(Source: Bloomberg)

In addition, as the Bank of International Settlements noted, extreme monetary policy divergence between US and Japan rises the costs for Japanese financial institutions to get dollar loans. Historically, cross currency basis swap spreads has been zero but started to fluctuate since the global financial crisis. As you can see it on the chart below, the US dollar premium in FX swap markets widened substantially and reached a record of -120bps in early March. At the moment, it would cost 0.9% a year for a Japanese banks to hold a perfectly hedge (currency and duration risk) 5-year US Treasury Bond.

JapanBasis

(Source: Horseman Capital Management)

Fixed income investors are starting to front run Kuroda and are purchasing bonds not based on the creditworthiness of the companies but on pure speculation that the BoJ will purchase them. With investors today in desperate need for yields, inflows in the high-yield (i.e. risky) market has been rising over the past few years. The problem those high-yield companies could face in the next few years is if interest rates start to rise, a run on those yield funds could push a lot of companies into bankruptcies.

Moreover, bond market functionality has been deteriorating as many investors are kind of forced to look elsewhere for bonds that are easy to trade (it takes longer to make a given trade). This lack of liquidity creates these sudden risk in volatility as we saw in the beginning of this year. The JPX JGB VIX Index measures the implied volatility of the 10-year JGB futures contract. At the moment, the index trades at 2.2 pts, which means that the market’s estimation of the price fluctuation of 10-year JGB futures over the next 30 days is expected to be 2.2% per annum. In the chart below, we can see that the vol index surged to almost 6 pts in the beginning of the year as a post-reaction of the Negative interest rate policy announced by Kuroda on January 29th. The last time we saw such a move was in April 2013 after the QQME announcement.

ImpliedVol

(Source: Bloomberg)

IV. Our view for the next five years

We strongly believe that the Japanese economy will continue to stagnate in the medium term, pushing or forcing Japanese policymakers to act even more. The nation citizens and the external investors will start to lose faith in Abenomics and therefore the macro tourists (investors that is looking at a short term opportunity) will withdraw their money from the equity market, potentially causing the Yen to appreciate in the beginning. However, in our view, Japan will face the so-called turning point between a currency devaluation and a currency crisis as the BoJ and the government will try all their best to protect the currency from appreciating.

Even though we think that we will sharp moves in the equity or bond markets, we are convinced that the best opportunity relies on the currency. If we look at the USDJPY chart below, despite a 36% depreciation that pushed the pair to 108 from the mid 70 levels, we stand far away from the 360 Yen per Dollar during the Bretton Woods area. We think that Japan needs another 50 to 100 percent currency depreciation to regain more competitiveness, which correspond to levels we saw back in the 1990s.

USDJPY

(Source: Bloomberg)

Since its return to the premiership in December 2012, Shinzo Abe has already become now Japan’s longest-serving prime ministers. However, his second term comes to an end in 2018 and the situation may start to deteriorate, gradually first then suddenly.

Consequently, sluggish growth in addition to a high debt burden and a shrinking population will not tend to push equities or real estate investments higher, raising the probability of a surge in non-performing loans. This is an episode that we already saw in the 90s after the bubble collapsed. We just think this time is different as the currency will not appreciate but depreciate.

Extreme monetary policy divergence to continue in the coming year…

We are conscious that the emergence of a potential crisis in the Japanese bond market will definitely shake the world’s economy as well. However, the depreciation will gradually be driven by an extreme monetary policy divergence coming in the next few quarters. The Federal Reserve chairman Janet Yellen expresses her views that the FOMC committee was ready to hike interest rates in the following months. A first hike was established in December last year after seven years of ZIRP policy run in the US as a response of the global financial crisis. Persistent QE in Japan (versus no money printing in the US since October 2014) in addition to short term interest rate differentials will constantly tend to push the currency USDJPY to higher levels.

In our opinion, there is no structural bids for the Yen anymore; each Yen appreciation that we experience since the announcement of QQME in April 2013 was a reaction to a sudden new risk emerging from the market followed by an investors’ response to ‘What is weak and what is cheap? The Yen’. To that extent, we strongly believe that each time there is an increase in the Yen’s value, it could be a good entry points for the new ones or a good to increase your long position on USDJPY, targeting 150 as a first level.

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.

 

 

Only BoJ matters…

Back in September 2014, we wrote an article It is all about CBs where we showed different central banks’ balance sheet as a share of the country’s GDP, which we thought could help explain exchange rates better than some macro models.

As you can see it on the chart below, the Bank of Japan’s balance sheet has been expanding drastically over the past three years and now held a total of 410tr Yen in assets. For an economy of roughly 500tr Yen, the ratio BoJ’s asset – to – GDP stands now at 82% (vs 20 to 30% for central banks).

Chart 1. BoJ Assets (Source: Japan Macro Advisors)

BoJAssets

When you think about it, the BoJ currently holds:

  • 35% of the JGBs (a ratio that is expected to grow to 50% by the end of 2017 – see chart 2).
  • 55% of the country’s ETFs (Chart 3). The BoJ is currently purchasing 3.3tr Yen of ETFs on an annual basis; if it accelerates its program to an annual rate of 7tr Yen, the central bank could become the first shareholder in about 40 of the Nikkei 225’s companies by the end of 2017 according to Bloomberg’s calculations.

Chart 2. BoJ’s JGBs holdings (Source: Japan Macro Advisors)

JGBsHolding

Chart 3. BoJ ETFs holdings (Source: Bloomberg)

ETFsJapan

On January 29th, Kuroda announced that the central bank will adopted negative interest rate policy in order to revive growth (and inflation) in the world’s third-largest economy. Like in the Eurozone (and many countries in the world), the BoJ has been charging a fee to excess reserves that financial institutional place at the central bank over the past three months now. However it doesn’t seem that the results are effective: Japan CPI switched to negative territory in March (-0.1% YoY) and is on the verge on entering into a quintuple recession since the GFC (see chart 4).

Chart 4. Japan’s GDP growth rate (Source: Trading economics)

JapanGDP

It looks like the market was expecting another ‘move’ from the BoJ overnight, and was disappointed by the status quo. The Nikkei index dropped 1000 points to close at 16,666 and sits now on its 50-day SMA, while USDJPY (white line) crashed almost 4 figures to 108, bringing down SP500 futures (blue line) with him to 2075. Therefore, these moves can conclude that for Japan, today, ‘only’ the BoJ matters in terms of news and the best you can do to ‘invest’ is to frontrun what Kuroda is doing.

Chart 5. USDJPY and SP500 futures (Source: Bloomberg)

USDJPYSP500

Some analysts or traders see a buy on dips opportunity at the moment (at around 108), however we would wait ‘til the US opens to decide such a trade. The VIX index (see chart below) has been trending upward over the past few days, which means we could see a couple of volatile days and a fly-to-quality to safe havens such as the Yen (or the Euro as well).

Chart 6. VIX index (Source: Bloomberg)

VIXindex

Japan update: Abenomics 2.0

As a sort of casual week end ‘routine’, I was watching the cross assets chart of the main economies that I usually follow. There are so many things that are happening at the moment, however a little update on Japan is always refreshing and useful.

The chart below shows the evolution of the equity market (Nikkei 225 index, Candles) overlaid with USDJPY (green line). As you can see, since Abe came into power in December 2012, there has been a sort of Pavlovian response to the massive monetary stimulus: currency depreciation has led to higher equities. However, the Nikkei 225 index closed at 17,725 on Friday and is down almost 15% from a high of 21,000 reached on August 11, whereas the currency has stabilized at around 120 and has been trading sideways over the past month with an 1-month ATM implied volatility down from 13.2 to 10.6% over the same period. If we look at the 20-day correlation (that I like to watch quite a bit) between the two asset classes, we are down from a high of 89% reached on August 24th to 38.1% in the last observation with an equity market being much more volatile.

EquityandYenC

(Source: Bloomberg)

In article I wrote back in September 2014 entitled The JPY and some overnight developments, I commented a bit on how Japanese Pension Funds (GPIF in my example) were decreasing their bonds allocation and switching to equities. And the questions I ask myself all the time is ‘Can the BoJ (and the other major CBs) lose against the equity market today?’ Indeed, the GPIF, which manages about $1.15 in assets, suffered a 9.4tr Yen loss between July and September according to Nomura Securities.

Abenomics 1.0 update…

We saw lately that Japan printed a negative GDP of 0.3% QoQ in the second quarter of 2015 and is potentially heading for a Quintuple-Dip recession in 7 years. In addition, the economy returned to deflation (for the first time since 2013) if we look at the CPI Nationwide Ex Fresh Food (-0.1% YoY in August, down from 3.4% in May 2014). We know that deflation and recession were both factors that Abe has been trying to fight and avoid, and the question is now ‘What is the next move?’

In a press conference on September 24th, PM Abe announced a sort-of new ‘arrow’ where the plan is to achieve a GDP target of 600 trillion Yen in the coming years (no specific time horizon mentioned as far as I know), which is 20% more from where the economy stands at the moment (JPY 500tr). In addition, he also target to increase the birth rate to 1.8 children per woman from the current low rate of 1.4 in order to make sure that the Japanese population don’t fall below 100 million in 50 years (from approximately 126 million today).

Clearly, this new announcement shows that the three-arrow plan has failed for the moment, and the BoJ only has been the major player in order to inflate prices over the past few years. I am wondering how this new plan is going to work in the middle of the recent EM economic turmoil. My view goes for additional stimulus, another 10 trillion Yen on the table which will bring the QQME program to a total of 90 trillion Yen. If you think about it, the BoJ is currently running a QE program almost as much as big as the Fed’s one in 2013 (85bn USD a month, 1 trillion USD per year) for an economy three times smaller than the US. Deceptions coming from Kuroda (i.e. no additional printing) could strengthen the Yen a little bit, but this will be seen as a new buying opportunities for traders or investors looking at the 135 medium-term retracement (against the US Dollar).

Here are a few figures and ratios to keep in my mind in the medium-term future…

Bank of Japan Total Assets

According to Bloomberg’s BJACTOTL Index, the BoJ’s balance sheet total assets increased by 210tr Yen since December 2012 and now stands at 368tr Yen. With an economy estimated at roughly 500tr Yen, the BoJ-total-assets-to-GDP ratio stands now at 73.6%.

JAPANassetC

(Source: Bloomberg)

Japan Banks total Assets

As of Q1 2015, the Japanese Banks reported a 1,818 trillion Yen exposure, which represents 363% as a share of the country’s GDP.

BanksJapanC

(Source: Bloomberg)

Based on the figures, you clearly understand that Japan’s government has been trying to push savers into stocks so Mrs Watanabe can take part of this artificial asset price inflation. However, a recent study from the Bank of Japan showed that Japanese households still had 52% of their assets in cash and bank deposits as of March 2015 (vs 13% for the American for instance).

The 15-percent recent drawdown in the equity market clearly shows sign of persistent ‘macro tourists’ investors, who are giving Abe and the BoJ board a hard time.

To conclude, the situation is still complicated in Japan, which is hard to believe based on the figures I just showed you. I strongly believe that Abe cannot fail in his plan, therefore if the new arrow needs more stimulus (which it does), we could see another 10 to 15 trillion on the table in the coming months. The medium term key level on USDJPY stands at 135, which brings us back to the high of March 2002.

FX ‘picking’, who is the one to watch?

For the past couple of months, volatility has declined in all asset classes and traders (and algos) have switched to a range trading attitude. If we have a quick overview of the market, we can see that the S&P500 is still fighting against the 2,100 level, the VIX is gradually approaching its crucial 12 level, core bond yields are trading a bit higher (Bund is up 10bps, trading at 16bps) and EURUSD is trading in the middle of its 1.05 – 1.10 range.

However, in a more detailed analysis, we heard some noise lately that trigger a bit of movements in the FX market.

1. SNB talks, first round…

The first one was the CHF move. A few days ago, I posted on my twitter account a chart (see tweet @LFXYvan on April 19) that I thought could be problematic for the Swiss economy (i.e. SNB). At that time, EURCHF was gradually approaching the 1.0250 level, down from 1.08 a couple of months ago (5% appreciation).

Then, a couple of days later, SNB comments sent he Swissy tumbling, with EURCHF and USDCHF up 150 and 200 pips respectively. In its comments, the SNB announced that it reduced the group of sight deposit account holders (bank account through which transfers in the form of cashless payments and cash deposits and withdrawals can be effected) that are exempt from negatives rates, therefore transferring the ‘negative carry’ to its clients and in hope that Sight Deposits are reduced.

Looking at the charts, it seems that it wasn’t enough to force investors to run away from the Swiss Franc and I think we are on the path to retest new lows on EURCHF and USDCHF. With Swissy becoming once again the safe-haven asset since the end of the floor in mid-January, SNB Jordan will have to do more to prevent the exchange rate from appreciating ‘too much’.

2. Cable: will the ‘hawkish’ minutes floor the currency losses ahead of the UK general election?

Yesterday’s BoE minutes trigger a bit of appetite for the pound and sent Cable to a 1-month high of 1.5070. As you can see it on the chart below, the currency is now flirting with its 50-day moving average, an important resistance that could halt the pair’s late bullish trend.

GBP

(source: FXCM)

To be honest, I didn’t understand the sort of positive GBP reaction based on the central bank’s report. If we look at the big lines, the Committee voted unanimously to keep the Official Bank Rate steady at 0.5% (as expected), and in the 23rd section, it says that policymakers were expecting the 12-month CPI rate to fall into the negative territory at ‘some point in the coming months’. It sounds more neutral (if not so, slightly dovish) than hawkish to me.

With the (uncertain) general election coming ahead, I’d rather keep a short position on Cable, especially at current levels. Conservatives should keep a tight stop at 1.5160 for a first target at 1.4750, however I would widen the room there and suggest a stop at 1.5250 (RR of 1.3).

3. Follow the CAD move

Another mover was the CAD, alongside rising prices for oil, which surged by 6 figures to hit a three-month low of 1.2090 on Friday before coming back to 1.22 (against the greenback). With the Western Canadian Select June futures trading at a 11.50 spread against the WTI and higher than expected inflation rate (1.2% YoY in March vs. 1% consensus), the probability of another 25bp cut from the BoC in order to counter a lower growth economic forecast was revised (lower) by the market. It could potentially cap USDCAD on the upside, first resistance is seen at 1.2280, then the second stands at 1.2400. I would be comfortable with a little short position on USDCAD, targeting 1.2180 at first (stop above 1.2360).

CAD

(Source: FXCM)

4. Trade the Yen from a ‘Technicals’ perspective

I will finish this article with the Yen and Japan latest news. We saw earlier this week that Japan Trade Balance saw a tiny JPY3.3bn surplus (vs 409bn deficit expected) after 48 months of trade deficits. Even though it should be considered as good news (for a country which is expected to see a current account deficit for the first time in 34 years), the reason of that tiny surplus was driven by a collapse in imports, that plunged by 14.5% YoY (the most since November 2009). The Good news for Abe (and Kuroda) is that the stock market closed above the 20,000 level this week for the first time in 15 years, making a least one of the arrows – monetary stimulus – work.
As the Yen still remains one of my favorite currencies to watch on a daily basis, I had a lot of conversations with some friends of mine, and we (almost) all agree each time that the BoJ will lose completely control of its currency in the medium/long term. If you look at Japan core figures (debt-to-GDP ratio of 240% according to the IMF, a declining population with more than 25% Japanese aged 65 or over – out of 127ml, massive stimulus as a share of the country’s GDP…), the problem is easily spotted and the biggest ‘opportunity’ will be in the currency market in the medium term.

However, I am more skeptical (i.e. less comfortable) with the short-term trading. Now that the currency has passed its safe-haven status to the Swissy (see tweet @LFXYvan on March 24), I am usually looking for some buy-on-dips opportunities. Being short USDJPY sometimes scares me in the way that I don’t understand how the market interpret good news or bad news in Japan (therefore I always keep a tight stop for short positions).

One thing I am still comfortable in saying that, in an intra-day basis, USDJPY and the equity market (SP500) are still ‘breathing’ together, therefore one of them will ‘carry’ the other.

The wide range on the pair would be 115.50 – 122, but based on today’s volatility I am looking at the 118.30 – 120.80 window. Any breakout of the window could lead to another ‘readjustment’; something I am going to watch closely. If the currency keeps approaching the high of the range, it could be worth going short at 120.60 with a stop above 121.00 and a target at 119.50.

JPY

(Source: FXCM)

Japan and the Yen, where do we stand now?

On October 31st, Governor Kuroda announced that the BoJ will raise (by a 5-4 majority vote) its bond-buying program. We saw the reaction since then; USDJPY soared from 112+ then to 120 (with a high of 121.86 on December 7). Some analysts think that the move was/is exaggerated, but if you put the figures on table, it looks reasonable to me. By announcing that the Bank of Japan will buy between 8 and 12 trillion JPY of JGBs each month, it means that it will purchase the total 10tr Yen of new bonds issued by the Ministry of Finance; in other words, full monetization. As a reminder, the central bank is the largest single holder of JGBs (with 20%+ of the shares), and could end up owing half of the JP bond market within the next 3 to 4 years.

With the country now in a triple-dip recession (GDP contracted by 1.9% in the third quarter) and the inflation rate slowing down for the fourth consecutive month in November (core CPI, which excludes volatile fresh food but include oil products, rose 2.7% in November, down from 2.9% in September and 3% in October), I see just more ‘power’ coming from Japanese policymakers. Elected in December 2012 as Japan PM (the seventh one in the last decade), I am convinced that Abe (and Kuroda/Aso) cannot fail this time and will (and must) continue to go ‘all-in- on his plan. That will mean aggressive easing, therefore constant depreciation of the currency JPY in the MT/LT. Remember the graph I like to watch: Central Bank’s total assets as a percent of the country’s GDP (see article It is all about CBs).

In fact, as many analysts have stated, the hit from the sales tax increase back in April turned out to be bigger than expected. The second one, which was set for October 2015 and would have seen a 2-percent rise to 10 percent, has already been postponed for early 2017 according to Abe’s announcement last month. When will the country work on its budget balance? As a reminder, Japan has been showing a 8%+ budget deficit over the past six years, which rose the level of its debt to a ‘unsustainable’ 230% as a share of GDP.

Another major problem that the third-largest economy will have to deal with in the long term is its population. The chart below (Source: the Economist) shows the evolution of Japan’s population from 1950 to 2055 (forecast). It is aging, and that is terrible news for all the pension or mutual funds as many people from the Japanese workforce will switch from being net savers to net spenders.

20141213_gdc700(Source: the Economist)

With a population of 127 million in 2013, the number of people is expected to fall below 100 million by the middle of this century due to the low birth of rate (total fertility rate of 1.4 in 2013).

In my article last month on the Japanese Yen History, I added a quick ‘technical’ chart and stated that we may see some take profit a 120 and that the pair should stabilize at around that level based on the downtrend line. And each time I have some discussion about the Yen, I always say there are two ways to play it:
– either keep it short (against USD or GBP) for those who are looking for a medium or long term view;
– or buy the pair (USDJPY) on dips if you try to catch nice trends. Don’t try to short it, unless you are really confident and have been doing it for a while. All traders I know are looking for buying opportunities on the pair.

Speaking of that, it looks to me that the core portfolio I have been carrying over the past few months now – Short EUR (1/2) , JPY (1/2) vs. long USD (2/3) and GBP (1/3) – has been quite profitable, and I still believe there is more room. At least, it makes sense on the idea I had about ‘monetary policy divergence’, with the US and UK considering raising rates (no printing/QE) while EZ and Japan aggressively printing with NIRP/ZIRP monetary policies. I will try to write a piece shortly on the Euro while I am working on my 2015 outlook.

Japan Exports: Back Before Abe…

Last night, data continue to disappoint in Japan as we saw that the June exports drop 2.0% YoY, far below the 0.7% rise expected and down from +18.5% back in October last year. We picked the chart below from Zero Hedge, which shows the evolution of Japanese Exports (black line) since Abenomics (December 2012) against market’s expectations (orange line). As you can see it, we are back to levels we were before Abe took office in the last quarter of 2012, raising doubts about the Abe-Kuroda strategy. On the other hand, imports increased 8.4% from the same year earlier.

image001

(Source: Zero Hedge)

The Finance Ministry reported that the Trade Balance deficit widened to 822bn Yen in June (vs 643bn Yen expected) and reached the two-year mark last month as exports failed to keep pace with surging imports. In the first half of the year, Japan’s trade deficit soared to a record 7.6tr Yen and is expecting to remain in the red area for the long term, which is becoming a serious issue for Japan PM Abe.

The Yen remained steady against the greenback on the news and has been trading within a tight 30-pip range (101.30 – 101.60) for the past few days. We believe that USDJPY looks vulnerable to the downside, and the first strong support stands at 101.00 (there are buyers around 101.00/10 and some at 101.25). As we mentioned it previously, a quiet equity market in Japan (Nikkei is range trading between 15,000 and 15,500) in addition to low US yields (10-year is back below the 2.5% since last week and now trading at 2.48%) make it difficult for the Yen to depreciate against the US Dollar.

JPY-24

(Source: Reuters)

Important figures to watch tonight are Japan June inflation data. The recent spike we saw after the sales tax increase (from 5 to 8 percent on April 1st) eased market’s expectations of further easing in the coming months, therefore capping USDJPY on the topside. The May nationwide core CPI rose 3.4% in May from a year earlier, the fastest since 1982, and is expected to ease down to 3.3% in June.
Even if we feel that USDJPY will remain under pressure in the coming weeks, we would position ourself on EURJPY at the moment after the spike we saw on the Euro. Short a current levels (137.00) with a first medium term target at 134.50.