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.

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.

Update on Kiwi, RNNZ on hold as expected…

The Kiwi has remained under pressure against the greenback since the middle of July when it flirted with its 3-year resistance at 0.8840. Since then, we saw a lower than expected CPI that printed at 1.6% in Q2 on July 15 (vs 1.8% expected) followed by a dovish stance from RBNZ policymakers on July 24th. Despite the central bank raised its OCR by 25bps for the fourth time this year to 3.5% (in line with investors’ expectations), Governor Wheeler indicated that the central bank was considering a pause in the following meeting after the 1% shift.

Therefore, investors lost interest in the currency (probably some take profits above 0.8800) and the negative trend started. I have remained bearish on the currency since the central bank’s last statement, and we anticipated the NZD to depreciate even more against the USD ahead of the RBNZ meeting (September 10th). As expected, the central bank left rates unchanged yesterday and added that ‘softer inflation might limit the extent of rate hikes’, pushing NZD/USD below the 0.8200 level (trading at 0.8175 as you can see on the chart below).

We set our target at 0.8050, which corresponds to February 2nd (2014) low.

KiwiDol(1)

(Source: Reuters)

Buy the dips on NZD/JPY?

It looks to me that the 14-day SMA (orange line) has been acting as a ‘strong’ support on NZD/JPY for the past couple of weeks. Despite our bearish sentiment on the Kiwi, we also turned bearish on the Yen and we believe that bearish Yen is preferable to bearish Kiwi. Therefore, we will try to buy some at around 87.30, stop loss below 86.90 with a target at 88.00.

NZD-11-Sep(1)

(Source: Reuters)

The JPY and some overnight developments…

The latest development that we found interesting lately was certainly USDJPY breaking out of its [four-month] 101 – 103 range on August 20. Despite US LT yields trending lower (10-year trading below 2.40%) and the BoJ showing no interest of increasing QE even though the economy printed dismal figures (except a strong CPI), the Yen has weakened by almost two figures in the past couple of weeks against the greenback and is now trading slightly below 105.

We were a bit surprised by this breakout as we thought until lately that the JPY had no reason to depreciate against the US Dollar (especially with a quiet BoJ and US LT yields expected to remain low in H2 according to analysts). Our thoughts was that the Yen depreciation mainly came from the carry trade positions (‘risk-on’ sentiment) with AUDJPY trading at new highs at around 97.50 (which corresponds to June 2013 levels), and we first assumed that the risk-on situation isn’t fully established and the market was just looking for ST opportunities and that any major ‘bad’ news could potentially trigger some massive carry unwinds as we saw previously (aka Yen appreciation).

However, after a few chats with some FX strategists (who we all thank for their kind answers), a first important thing to notice is the decrease in the 6-month (daily) rolling correlation between AUDJPY and S&P500 from 67% back in mid-February this year down to 47% today. In other words, the Japanese Yen sensitivity to risk-off moves has fallen as you can see it below in the Bloomberg Spread Analysis.Audcorr

(Source: Bloomberg)

Secondly, traders and investors are becoming more confident on a BoJ move later on this year, and further easing by JP policymakers (after Japan dismal figures: July household spending collapsed 5.9% YoY, Q2 GDP shrank by annualized 6.8% erasing Q1 gains, Housing starts down 14.1% in July…) is the main driver on Yen weakness according to analysts.

Eventually, another factor to look at would be Japanese institutional investors switching from bonds to stocks (and international stocks and bonds); we saw strong demand for French OAT from Japan last week. For instance, as you can see it below, GPIF, Japanese 1.2-trillion-dollar retirement fund, reduced its domestic bonds holdings by almost 10 percent in the past 3 years and has gradually increased its holdings of Japanese equities and International Bonds and Stocks. In June this year, it reported that it held 53.36% of domestic bonds and 17.26% of domestic stocks, down from 62.64% and 12.37% respectively back in 2011 (Abe’s effect). As a reminder, GPIF has a 60% target for domestic bonds and 12% for Japanese stocks, with 8% and 6% deviation limits respectively for those assets.

Gpif

Having said that, the 105 level could potentially act as a psychological resistance at the moment, next important level on the topside stands at 105.44, which corresponds to January 2nd high. USDJPY looks a bit overbought as you can see it on the chart below, and we will look for lower levels to start considering buying some more.

JPY-2-Sep(1)

(Source: Reuters)

Aussie pausing as expected…

The late US Dollar rally (USD index flirting with 83.00, its highest level since July 2013) hasn’t impact the Aussie (that much) and AUDUSD is still trading within its 5-month 0.92 – 0.95 range. The RBA left its cash rate steady at 2.50% (as expected) and looks unlikely to change it for some time, which is what we were assuming (see our article RBA is giving up…). The BBSW rates, which correspond to transparent rates for the pricing and revaluation of privately negotiated bilateral Australian dollar interest swap transactions, are trading quite flat with the 1-month and 6-month bills paying 2.66% and 2.69% respectively.

Despite AU annual inflation approaching the high of the RBA [2-3] percent inflation target range (Trimmed mean CPI came in at 2.9% YoY in the second quarter), AU policymakers noted slack in the job market and rising house prices.

The trend on AUDUSD looks bearish at the moment; we will try to sell some if the pair pops back above 0.9300 ahead of US employment reports on Friday. I’d put an entry level at 0.9330, with a tight stop loss at 0.9360 and a target at 0.9210.

Figures to watch this week:

AU GDP YoY (sep. 3rd): expected to ease back to 3.0% in the second quarter, down from 3.5%.
AU Trade balance (Sep 4th): expected to come in a -1.51bn AUD in July.
US Non-Farm Payrolls (Sep 5th):  expected to print at 225K in August, above the 200K level for the for the seventh consecutive month.

No action from CBs, back to long carry positions…

The last updates we had from the BoE (Quarterly Inflation Report) and the last disappointing US figures showed clearly that the two major CBs (Fed and BoE) are not ready to tighten. Therefore, vols are dead once again pushing carry trades preferences, despite overall geopolitical risks…

The sell-off that you can see on both chart was due to Ukraine announcing that troops were attacking convoy, which generated some carry unwinds…

If you have a look at the chart below,  AUDJPY (black bars) is now back to the high of its 93.00 – 96.50 range (95.60 current level), up from 94.00 last Friday, lifting the equity market higher. The S&P500 (purple line) is up 60 points (3.1%) and now trading above the 1,960 level.

AUDYen(1)

(Source: Reuters)

EM side: If we replace AUDJPY by MXNJPY (black bars), we get pretty much the same correlation, which once again confirms CNBC Rick Santelli’s favourite sentence ‘it is all about the carry trade’. We would put it that way: ‘ it is all about the Yen…’
MXNJPY is up 20 figures since last Friday (+2.6%)…

MXNYen(1)

(Source: Reuters)

Recovery mode after market turbulence

Markets have been pretty shy this week, with equities recovering after two weeks of ‘correction’.
The S&P500 found support slightly above the 1,900 level on Friday after a 4.35% decline since July 24 high of 1,991.39. Market sentiment worsened as Obama launched another Iraq Assault, with traders potentially willing to put on some bearish positions; however it seems to me that markets don’t seem to be able to handle increasing risk well. AUDJPY eased 150 pips to find support at 94.40, which means that we reached our target of 94.60 based on our previous trade recommendation (see here).

AUDSP(2)

(Source: Reuters)

Another sharp move was in the German market with the benchmark DAX index (blue line) off more than 11% between July 2 high (10,032.28) and last Friday’s low of 8,903.49. If you add the French and UK benchmark indexes (FTSE100 in red and CAC40 in orange), you can see that they had approximately the same path (see graph below), both down 4.3% and 7.5% respectively.

Equities(1)

(Source: Reuters)

The single currency remains under pressure after last week equities sell-off and disappointing fundamentals. EURUSD is trading at a 9-month low, slightly below the 1.3350 level, after German ZEW survey came in well below expectations yesterday as geopolitical tensions and the sluggish recovery weigh on the European’s largest economy. Russia is one of Germany’s main trading partners, therefore there are signs that the German economy will grow at a lower rate than expected in 2014. As a reminder, final Q1 GDP came in at 0.8%; growth is expected to be flat on Q2 according to analysts’ first estimates.

Traders will watch EZ Q2 GDP first estimate and the final July CPI tomorrow, which are expected to come in at 0.1% QoQ and 0.4% YoY respectively. We are still bearish on EURJPY (entered at 137.20 with a MT target at 134.10), mainly based on a Euro weakness (ECB easing in addition to poor fundamentals).

Yen: The BoJ two-day meeting didn’t change any forecast on USDJPY, and the pair is still stuck within its 101-103 range for the past four months (couple of exceptions). Equities sell-off (Nikkei index down 1,000 pts between July 31 and Aug 8) combined with low US yields (10-year bottomed at 2.35% on Friday and is now trading slightly above the 2.40% level) played in favour of the JPY. USDJPY was sold to 101.50 on Friday and is now trading in the middle of its 200-range. Last night, we saw that Japan Q2 GDP collapsed by 6.8% according to Japan’s Cabinet Office (slightly less than the 7.1% expected), its worst contraction since 2011. While inventories additions added 1.0% growth, consumer spending fell 5.2% QoQ after the nation increased its sales tax from 5 to 8 percent on April 1st. We will get back to Japan this week with an article focused on its economic outlook and what are BoJ policymakers’ options.

Markets after Yellen…

There have been some interesting developments for the past few days in the middle of this low-volatile environment. Firstly, Fed Chair Yellen opened two days of testimony on Capitol Hill yesterday, delivering the central bank’s semi-annual report to Congress. With the QE-Taper to end in October (already priced in), the market was waiting for more details concerning the ‘future path’ of the Fed Funds target rate (currently at a historical low of 0-0.25%). Despite strong employment data with Non-Farm Payrolls printing above the 200K level for the fifth month in a row in June (288K) and the jobless rate that edged down by another 0.2% to 6.1% (2008 levels), Yellen clearly stated that the US economic recovery ‘is not yet complete’ with the housing market showing ‘little progress’ but still disappointing this year.

However, she surprised the market a bit when she told the Senate Banking Committee that rates could rise sooner than planned. These comments ‘kind-of’ played in favour of the US Dollar, with USD index trading 80.50 at the moment. Its main component, the Euro (57.6%), broke out of his tight 1.3575 – 1.3675 range and is now trading at 1.3540 (see chart below). The next support on the downside stands at 1.3520, the 38.2% Fibonacci retracement of 1.2750 (July 2013 low) and 1.3992 (May 2014 high).

EUR-16-Jul

(Source: Reuters)

The second interesting development was the higher-than-expected CPI figures in UK that gave a boost to Cable after its last two weeks of weakening momentum. Annual inflation came in at 1.9% YoY in June (vs expectations of a 1.6% print), while CPI MoM increased by 0.2% (vs -0.1% consensus). It reinforced the market’s view that the BoE will be the first major central bank to lift rates. Even though some analysts are expecting a first move from UK policymakers later this year, we personally think that Q1 2015 sounds more reasonable. If we have a look at short-sterling interest rate futures, the March 2015 contracts sold off to 98.91 from 98.97, which means that the implied yield from 103bp to 109bp. Earlier this morning, UK claimant counts fell by 36.3K in June, following a revised 32.8K drop registered in May. The jobless rate edged down to 6.5% as expected.

After it reached a high of 1.7191 yesterday afternoon, Cable remains poised for a break above 1.7200 and is now trading at 1.7125. The first support on the downside stands at 1.7100, followed by 1.7060. A more interesting pair would be EUR/GBP, which is now trading at a 22-month low at 0.7900 and is approaching its next support at 0.7880 (see chart below).

EURGBP-16-Jul

(Source: Reuters)

Another surprise came from New Zealand where inflation accelerated less than expected, easing pressure on the RBNZ to continue its monetary policy tightening cycle. As a reminder, the central bank has increased its overnight cash rate (OCR) three times to 3.25% since the beginning of the year, and the market is still expecting a 25bps rate hike at the next meeting on July 23rd. We felt that the Kiwi strength would probably weigh on NZ policymakers’ decision at the next meeting, therefore we were expecting a correction on NZD (see our last trade short NZD/JPY). It was also interesting to play a technical bear correction on NZD/USD when the pair was flirting with its 3-year high as you can see it on the chart below.

NZD-16Jul

(Source: Reuters)

Quick update on BoJ and the Yen: USDJPY continues to trade sideways after the BoJ decided to keep its monetary policy unchanged (as expected), maintaining its target of increasing the monetary base at a annual pace of JPY60-70tr per year. The central bank cut its 2014 growth prediction to 1.0% (down from 1.1% last meeting and from 1.5% last October), but the board (9 members) unanimously maintained its inflation projection of 1.9% in the next fiscal year. If we have a quick look at the chart below, USDJPY is still trading within its tight 101.00 – 103.00 range. It found support slightly above the 101.00 level last week and seems on its way to test its next resistance at 101.94 (200-day SMA).

JPY-16-Jul

(Source: Reuters)

To finish, another currency AUDUSD that we have been trying to play lately is AUDUSD. The RBA minutes didn’t surprise the market on Tuesday despite AU policymakers’ willingness to see a lower Aussie (the minutes stated ‘the exchange rate remained high by historical standards’). We still think it is interesting to go short AUDUSD if the pair trades above 0.9400, with a medium term target at 0.9200 and a stop loss above 0.9560.

AUD-16Jul

(Souce: Reuters)

Update on Japan and Yen

Lately, there were lots of talks about more QE in Japan, in order to stimulate the economy which could be impacted in the coming months by the sales tax increase that occurred on April 1st. If we summarise the economic data in the past few weeks, we saw a huge decline in April retail sales (-13.7% MoM, the largest decline on record), a decreasing Manufacturing PMI which now stands below the 50-recession level (49.4), a shrinking current account that recorded a ‘tiny’ surplus of ¥789.9bn in 2013 compare to ¥4.2tr in FY2012, a lower-than-expected Industrial Production (Prelim IP came in at -2.5% in April vs. 2.0%) and household spending that shrank 4.6%. It is clear that Japan is beginning to show the impact of the tax increase. And even though Q1 GDP expanded by 5.9% (annualized), the economy is expected to contract by 3% in the second quarter according to economists. In their last meeting (May 11), Bank of Japan policymakers warned that exports may remain weak in the near future due to sluggish demand from Asian countries.

However, an adjustment of the monetary policy at the moment remains tricky based on the last inflation data update. As expected, the institution of this consumption tax pushed inflation to 3.2% (Core Nationwide YoY) in April from 1.3% the previous month, well above the central bank’s 2-percent target.

Focus on USDJPY:

As the market expectations of new stimulus by the BoJ are being reconsidered, we are wondering if we could see a pause in USDJPY (or a sort of cap above the 103.00 level) in the medium term. Moreover, we need a turn in US yields (with higher vols in Treasuries), which have entered into a bearish momentum since the beginning of April. The 10-year yield decreased from 2.81% on April 2nd to 2.40% on May 28th and is now trading slightly above 2.52%. The sharp correction in the Nikkei (-9.4% YtD to May 31st) has also been one of the forces underpinning the yen.

USDJPY is now trading around its 100-day SMA (102.35), and the next resistance stands at 103.00 (April 5th high). However, with technical indicators showing neutral signals, it feels like the positive trend we have seen in the last couple of weeks is about to end (lower low between now and 103.00).

USDJPY-03-J

(Source: Reuters)

FOMC minutes review, what’s next for the Dollar-Bloc currencies?

Yesterday, the Fed released its minutes of the last FOMC meeting (March 18-19) and we saw that the US policymakers were less hawkish than expected, easing rate hike speculation. Despite the last two NFP good prints and unemployment rate standing slightly above the ‘once-to-be’ 6.5-percent threshold (6.7% in March), the recovery is still fragile according to Fed officials who surprised traders and investors by showing that the central bank was more supportive of keeping its Fed Funds rate at low levels (0-0.25%).The US Dollar index broke its support at 79.75 and is now trading at 79.40, boosting most of the currencies.

As you can see it below, the US 10-year yield (orange) eased by 7 bps to trade at 2.65%, pushing the price of Gold (purple) back to 1,320 and helping the Yen (green) to continue its ‘strengthening episode’. Since last Friday’s high of 104.12, USDJPY has depreciated by 2.4% and seems on its way to test its support at 101.20. At the same time, the 10-year yield is down 15bps from 2.80%.

USYields

(Source: Reuters)

Is there more room on the upside for the Dollar-Bloc currencies?

AUD: The Aussie continues its positive momentum with Australian March employment report smashing expectations of a 5K increase to print at 18,100 (Jobless rate edged down by 0.2% to 5.8%). The Australian Dollar is now trading above 0.9400, levels we saw back in October. We believe that the inflation figures coming up at the end of the month (April 23rd) will determine the stance of monetary policy and if Governor Stevens could threaten the market once again of a rate cut if he judges that the Aussie is ‘uncomfortably high’. If we have a look at the chart below, the last ‘Aussie recovery’ was stopped after a 10% increase when it hit its 200-Daily SMA at around 0.9750 with the RSI indicator (14 days, 30-70) showing an overbought signal. In the second recovery episode, the pair is up 9.3% since the end of January and seems on its way to test the 0.9500 level. However, the overbought RSI may have been perceived by traders as a good time to start shorting the pair.

AUD-10-APr

(Source: Reuters)

NZD: The Kiwi also appreciated sharply against the greenback and is up 8.65% since the end of January, trading at 0.8700 (August 2011 level). The Reserve Bank of New Zealand raised its Official Cash Rate (OCR) by 0.25% at its last meeting in March after holding it at a historical low of 2.5% for three years. Traders have been looking at the Kiwi as an interesting buying opportunity after Governor Graeme Wheeler announced that he expected to ‘raise the benchmark interest rate to about 4.5% in the next two years’ in order to curb inflation. Moreover, the unemployment rate declined to a 5-year low of 6.0% in the last quarter of 2013, while the economy expanded by 3.1% (down from 3.5% in Q3) and NZ’s current account deficit narrowed to NZD 7.55bn (or 3.4% as a share of GDP) through the twelve months through December (lowest ratio since Q1 2012).

The RBNZ will probably leave its OCR unchanged on April 23rd, which could hurt the Kiwi in the short term as some traders will start considering to take profit after the sharp appreciation. We would stay aside of the Kiwi at the moment and wait for further reaction from RBNZ policymakers on the strong exchange rate. The next resistance on the topside stands at 0.8840, which is the pair’s all-time high (Aug 1st 2011).

Kiwi

(Source: Reuters)

CAD: The surprise came from Canadian macroeconomic figures that completely reverse the bearish trend on the Loonie against the greenback. In its last meeting back in January, Bank of Canada lowered its inflation forecast stating that it expected the total inflation rate to remain at 0.9% in the first half of 2014, down from its previous forecast of 1.2%. As policymakers stated that they expected inflation to remain ‘well below target’, Governor Poloz turned the monetary policy to a dovish stance and the market was starting to price in a rate cut in one of the following meetings (currently at 1% since September 2010). However, the sudden increase in CPI (from 0.7% in October to 1.5% in January, then 1.1% in February) in addition to the better-than-expected indicators (GDP figures, Retail sales, Trade balance, Employment report…) brought back traders’ interest on the Loonie.

However, We think that the bearish trend on USDCAD is coming to its end and we will see 1.0800 as a good level to start buying the pair for a bounce back towards 1.1000 at first. USDCAD broke it 100-daily SMA yesterday (1.0900) and found support at 1.0850; technical indictors RSI is starting to show some oversold signals therefore some investors will see the 1.0800 – 1.0850 range as a buying opportunity.

USDCAD

(Source: Reuters)