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

Quick thoughts ahead of the Fed’s minutes…

Last month (October 8th), while many investors were quite confident on the US Dollar strength momentum, the minutes of the FOMC’s September 16-17 policy meeting clearly showed us a message from US policymakers.

If you ask me if we see a stronger dollar in the LT against most of the currencies, we would answer yes and without any doubt. we think the Fed is comfortable with a Dollar appreciation, however we strongly believe they want the process to be slow and gradual. Despite strong recent fundamentals (another NFP above the 200K level in October for the 9th consecutive time, an annual 3.5% first Q3 GDP estimate, ISM Manufacturing PMI still above 50, Housing Start fluctuating around 1mio for the past year…), global economic issues will weigh on US policymakers this time.

Let’s start with the first issue: the decline in oil prices. December Crude Oil WTI futures contract (CLZ14) is down $30 since end-of-June’s high, now trading below the $75 level. While we mentioned in one of our previous article that the decline in oil prices will be problematic for a lot of OPEC countries (see article Oil Breakeven Prices), it is now entering into critical levels even for the US. We heard and read that low oil prices could be seen as a stimulus for consumers, however it is now at levels hurting US shale production. According to some experts, most shale oil fields breakeven is seen between $70 and $75 per barrel (see chart below from Barclays Research).

ShaleBreakeven

(Source: Barclays)

 As a reminder, the US, now producing around 8.5 million barrels per day (8.65mio in August 2014 according to the Energy Information Administration), was expected to surpass Russia within the next 10 years and grow its production by 35% to approximately 11.5mio barrels per day (see chart below from the Wall Street Journal).

OilProduction

(Source: Wall Street Journal)

Therefore, if prices continue to fell, the party could end earlier than expected. In addition, lower oil prices will add pressure on inflation expectations and the 2-percent target that the Fed is watching desperately. Important figure to watch tomorrow, CPI inflation is expected to remain steady at 1.7% in November. Any print below that would create a bit of US Dollar weakness as traders will start to lose credibility on the quantitative definition of ‘considerable time’.

Speaking of disinflationary pressures, let me go to the second issue: Dollar strength. Back in the minutes, Fed officials mentioned that they saw ‘rising dollar as a risk to exports and growth’. At that time, the USD index was trading at a 4-year high above the 86 level, and up 8.5% approximately since July low of 79.78. Today, the index is trading at even higher levels (87.60), thanks to the BoJ and the Yen development and EM meltdown. We saw that September US trade balance printed its biggest deficit since April at $43bn (vs. $40.2bn consensus), up from $40bn the previous month, due to a decline in exports (down 1.5%). In our opinion, ‘Dollar strength’ will be one of the topics tonight, therefore we could see some dollar weakness after the release. In addition, Dollar strength will also weigh on inflation expectations in the US (we don’t think the inflation effect of dollar appreciation is negligible, especially couple with lower oil prices).

Therefore, we see a bit of disappointment this evening, and we will encourage some of the US Dollar bulls to cut some of their long positions. The Euro and especially the British pound could recover from their recent losses, technical resistances are seen at 1.2670 and 1.5800 respectively.

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.